Chapter 7
Financial Liberalization:
What Went Right,What Went Wrong?
T
HE FINANCIAL LIBERALIZATION
that took place in the developing
countries in the 1980s and 1990s
was part of the general move toward giving markets
a greater role in development. It was also a reaction
to several factors specific to finance: the costs, corruption, and inefficiencies associated with using
finance as an instrument of populist, state-led development; a desire for more financial resources; citizens’ demands for better finance and lower implicit
taxes and subsidies; and the pressures exerted on
repressed financial systems by greater international
trade, travel, migration, and better communications.
The financial reforms went beyond the interest
rate liberalization that had been recommended by
the so-called Washington Consensus. To varying
degrees, governments also allowed the use of foreign
currency instruments and opened up capital
accounts. Domestic markets developed in central
bank and government debt, and international markets expanded in government and private bonds.
Capital markets developed, but less rapidly, and were
most successful in the larger, already rapidly growing,
East and South Asian countries. State banks continued to have a major role for much of the 1990s; their
privatization was gradual and often proved costly.
Central banks moved away from trying to finance
development; they became more independent and
successfully focused on keeping inflation low, but
their debt increasingly absorbed bank deposits.
Certainly the reforms produced some gains. But
the growth benefits of the financial and nonfinan-
cial reforms in the 1990s were less than expected.
Financial crises raised questions of whether financial liberalization was the wrong model, what had
gone wrong, and the appropriate direction of future
financial sector policy. Overall, the 1990s is probably best considered a precursor of better things that
will take some time to achieve.
Section 1 of this chapter describes why and how
financial liberalization occurred. Section 2 discusses
the outcomes of financial liberalization during the
1990s, including the crises that occurred and their
relation to macroeconomic policies, financial liberalization, and the overhangs of old economic and
political systems. Section 3 summarizes the lessons
from the experience of the 1990s, and section 4
draws suggestions for future policy. Section 5 concludes the chapter.
1. From Financial Repression to
Financial Liberalization
The financial repression that prevailed in developing and transition countries in the 1970s and 1980s
reflected a mix of state-led development, nationalism, populism, politics, and corruption. The financial system was treated as an instrument of the
treasury: governments allocated credit at belowmarket interest rates, used monetary policy instruments and state-guaranteed external borrowing to
ensure supplies of credit for themselves and public
sector firms, and directed part of the resources that
207
E C O N O M I C G ROW T H I N T H E 1 9 9 0 s
208
Factors behind Financial Liberalization
Three general factors provided an impetus for the
move to financial liberalization: poor results, high
costs, and pressures from globalization.This section
discusses each in turn.
Poor Results
Together, the limited mobilization and inefficient
allocation of financial resources slowed economic
growth (McKinnon 1973; Shaw 1973). Low interest rates discouraged the mobilization of finance,
and bank deposit growth slowed in the 1980s in the
major countries (figure 7.1). Capital flight occurred
despite capital controls (Dooley et al. 1986).Allocation of scarce domestic credits and external loans to
government deficits, public sector “white elephants,” and unproductive private activities yielded
FIGURE 7.1
Increase in Average Deposits/GDP in Major
Countries, by Regions, 1960s–-90s
(difference between 3-year average of bank deposits/GDP at
the end of each decade)
30%
Percentage of GDP Increase
were left to sectors they favored. State banks were
considered necessary to carry out the directed
credit allocations,1 as well as to reduce dependence
on foreigners. Bank supervisors focused on complying with the often intricate requirements of
directed credit rather than with prudential regulations. Interest rates to depositors were kept low to
keep the costs of loans low. In some cases, low
deposit and loan rates were also populist measures
intended to improve income distribution.2
Repressed finance was thus an implicit tax and
subsidy system through which governments transferred resources from depositors receiving low
interest rates (and from those borrowers not receiving directed credits) to borrowers paying low rates
in the public sector and to favored parts of the private sector. Governments had to allocate credit
because they set interest rates that generated excess
demand for credits. Capital controls were needed
not (as often argued) to protect national saving, but
to limit capital outflows fleeing low interest rates
and macroeconomic instability, and to increase the
returns from the inflation tax.3 In effect, capital
controls were a tax on those unwilling or unable to
avoid them and they encouraged corruption (Hanson 1994).
25%
20%
15%
10%
5%
0%
–5%
1960s
1970s
1980s
1990s
South Asia (3 countries)
Africa (10)
Latin America (7)
East Asia (4)
Source: IMF, International Financial Statistics.
Note: Countries and regions covered are:
East Asia: Indonesia, Republic of Korea, Malaysia, the Philippines,
Thailand.
Latin America: Argentina, Brazil, Chile, Colombia, Mexico, Peru,
República Bolivariana de Venezuela.
Africa: Ghana, Kenya, Nigeria, Tanzania, Uganda, Burkina Faso,
Cameroon, Côte d’Ivoire, Mali, Senegal.
South Asia: Bangladesh, India, Pakistan.
low returns, crowded out more efficient potential
users, and encouraged wasteful use of capital.
Financial repression also worsened income distribution. Subsidies on directed credits were often large,
particularly in periods of high inflation, and actual
allocations often went to large borrowers.4 The low
interest rates led to corruption and to the diversion of
credits to powerful parties. Diversions tended to grow
over time, particularly when inflation reduced real
interest rates on credits, and rising fiscal deficits and
directed credits absorbed more of the limited deposits.
High Costs
The repressed systems were costly. Banks, particularly
state banks and development banks, periodically
F I N A N C I A L L I B E R A L I Z AT I O N : W H AT W E N T R I G H T, W H AT W E N T W RO N G ?
required recapitalization and the takeover of their
external debts by governments. Political pressures
and corruption were widespread. Loan repayments
were weak because loans financed inefficient activities, because loan collection efforts were insufficient,
and because borrowers tended to treat loans from
the state banks simply as transfers.Typically, banks
and other intermediaries rolled over their nonperforming loans until a period of inflation wiped out
depositors’ claims and permitted a general default.
Since intermediaries were not forced to follow reasonable prudential norms or mark their portfolios to
market, the losses were nontransparent, even to the
governments that often owned them. Inflation also
helped to conceal the problems of commercial banks
through their earnings on low interest deposits.The
hidden costs of the repressed systems became more
apparent once financial liberalization began.
Pressures from Globalization
Perhaps most important, financial repression came
under increasing pressure from the growth of trade,
travel, and migration as well as the improvement of
communications.5 The increased access to international financial markets broke down the controls on
capital outflows on which the supply of low-cost
deposits had depended.6 Capital controls may be
effective temporarily, but over time mechanisms
(such as overinvoicing imports and underinvoicing
exports) develop to subvert them (Arioshi et al.
2000; Dooley 1996). These mechanisms became
more accessible as goods and people became more
internationally mobile.
The Evolution of Financial Liberalization
The shift in policies differed in timing, content, and
speed from country to country and included many
reversals. Broadly:
• African countries turned to financial liberalization in the 1990s, often in the context of stabilization and reform programs supported by the
International Monetary Fund and World Bank,
as the costs of financial repression became clear.
209
• In East Asia, the major countries liberalized in the
1980s, though at different times and to different
degrees. For example, Indonesia, which had liberalized capital flows in 1970, liberalized interest
rates in 1984, but the Republic of Korea did not
liberalize interest rates formally until 1992. Low
inflation generally kept East Asian interest rates
reasonable in real terms, however. In most countries, connected lending within industrial-financial conglomerates and government pressures on
credit allocation remained important.
• In South Asia, financial repression began in the
1970s with the nationalization of banks in India
(1969) and Pakistan (1974). Interest rates and
directed credit controls were subsequently
imposed and tightened,but for much of the 1970s
and 1980s real interest rates remained reasonable.
Liberalization started in the early 1990s with a
gradual freeing of interest rates; a reduction in
reserve,liquidity,and directed credit requirements;
and liberalization of equity markets.
• In Latin America, episodes of financial liberalization occurred in the 1970s but financial repression returned, continued, or even increased in the
1980s, with debt crises, high inflation, government deficits, and the growth of populism (Dornbusch and Edwards 1991).In the 1990s,substantial
financial liberalization occurred, although the
degree and timing varied across countries.
• In the transition economies, financial liberalization took place fairly rapidly in the 1990s in the
context of the reaction against communism
(Bokros, Fleming, and Votava 2001; Sherif, Borish, and Gross 2003).
The earliest policy changes generally focused on
interest rates. In many instances governments raised
interest rates with a “stroke of the pen” to mobilize
more of the resources needed to finance budget
deficits and to enable the private sector to play a
greater role in development. (Some interest rate
increases, designed to curb capital flight, were
intended more for stabilization than for liberalization.) New financial instruments were introduced
210
that had freer rates and were subject to lower
directed credit requirements. Some countries also
began admitting foreign currency deposits, to attract
offshore funds and foreign currency holdings into
the financial system as well as to allow residents legal
access to foreign currency assets (Hanson 2002;
Honohan and Shi 2003; Savastano 1992, 1996).
Partial interest rate liberalizations soon generated
pressures for more general freeing of interest rates
(albeit in some cases after reversals of liberalization).
As borrowers directed funds into deregulated instruments and sectors, demand for low-cost loans
increased and repayments on them deteriorated.7
Unfortunately, when the macroeconomic situation
was unstable and interest rates were freed, very high
real interest rates developed, creating corporate and
banking problems that added to the overhang of
weak credits that were exposed by liberalization.
At very different speeds in different countries,
interest rate liberalization came to be supplemented
by other changes:8
• Central banks were made more independent.
They abandoned their earlier developmental role
to focus on limiting inflation, often in the context of stabilization programs.
• Reserve requirements and directed credit were
eased.
• Capital accounts were liberalized, even in countries where domestic foreign currency instruments remained banned. Foreigners were
allowed to participate in capital markets9 and
private corporations were allowed to raise funds
offshore.
• Markets were set up for central bank debt and
government debt. Equity markets were set up in
the transition countries and liberalized where
they already existed.
• In some countries, pension systems added
defined contribution/defined benefits elements,
often operated by private intermediaries.
• Gradually, state banks were privatized. Banking
competition increased, as a result of the entry of
E C O N O M I C G ROW T H I N T H E 1 9 9 0 s
new domestic and foreign banks and, in some
cases, nonbank intermediaries.
In general, however, the financial reforms of the
1990s focused on freeing interest rates and credit
allocations, and made much less effort to improve
the institutional basis of finance—a much harder,
longer task.
2. Outcomes in the Financial
Sector during the 1990s
Private sector credit is a key factor in growth.10
Banks can intermediate funds and take risks only if
private credit is not crowded out by government
debt. Over the 1990s, deposits grew faster than in
the previous decade, but in many countries bank
credit to the private sector from domestic sources
grew only slowly. The increase in loanable funds
was largely absorbed by the public sector.
Deposit Growth
Bank deposits grew as a share of the gross domestic
product (GDP) in the 1990s, unlike in the 1980s
(figure 7.1 above and Hanson 2003b). Thus, most
major countries and most regions achieved a major
objective of financial liberalization. And in India
and some East Asian and Latin American countries,
nonbank deposits supplemented the rapid growth
in bank deposits.
Box 7.1 discusses the resumption of deposit
growth in India as it gradually liberalized, as well as
the growth of India’s capital market.
Many factors contributed to the deposit growth,
including the slowdown in inflation in the 1990s,11
the positive real deposit rates, and new deposit
instruments. Another factor was the legalization of
foreign currency deposits. Deposits in foreign currency grew as a share of total deposits in many
countries in the 1990s, and in some cases they supplied more than half the total by the end of the
decade (Honohan and Shi 2003).12 Not surprisingly, the foreign currency deposits were popular
F I N A N C I A L L I B E R A L I Z AT I O N : W H AT W E N T R I G H T, W H AT W E N T W RO N G ?
211
BOX 7.1
India—A Successful Liberalizer with Strong Capital Markets
I
ndia liberalized its financial sector gradually over
the 1990s, with particular success in capital markets, while avoiding any major crisis. In the
1980s, India had a repressed financial system (Hanson 2001, 2003a). This, plus increasing macroeconomic instability, slowed deposit growth. Financial
liberalization was part of greater reliance on the private sector after the 1991 foreign exchange crisis.
Interest rates were raised and gradually freed, bank
regulations and supervision were strengthened, and
nonbank financial corporations (NBFCs) were allowed
under easier regulations (Hanson 2003a). After a 1991
capital market crisis, regulations were strengthened,
listings were liberalized, foreign investors were
allowed in, and infrastructure was substantially
improved (Shah and Thomas 1999; Nayak 1999).
Bank deposits of nationals and nonresident Indians
resumed their growth and NBFC deposits grew sharply
after 1992. The stock, bond, and commercial paper markets became among the most vibrant in developing
countries, providing nearly one-fourth of India’s corporate funding from 1992 to 1996 (Reserve Bank of India
1998) with listings more than doubling from 2,000 in
1991 to over 5,000 (Standard and Poor’s 2003). The
post-1997 economic slowdown led to a stock market
fall, problems in the NBFCs (which were wound down),
and crises in the government development banks and
mutual fund, though public sector commercial banks
performed surprisingly well. Recently, large capital
inflows and higher growth have led to low interest rates
and better bank performance.
Although India’s approach to financial liberalization
served it well, three major issues remain: (1) crowding
out, with government debt now absorbing more than
37 percent of bank deposits compared to about 24 percent at the end of the 1980s; (2) a weak information
and legal framework, which, despite efforts at improvement, still contributes to nonperforming loans and limits access to credit; and (3) the still-dominant role of
public sector banks.
75
75
M3+NBFCs % of GDP
M3/GDP
Avg. M3/GDP, 1987–92
45
45
Interest rate
1 year deposit
30
Inflation (CPI)
30
15
15
0
0
Source: Reserve Bank of India data.
CPI. Consumer price index.
GDP. Gross domestic product.
2001
–15
1999
1995
1993
1991
1989
1987
1985
1983
1981
1979
1977
1975
1973
–15
1997
Free
rate
M3 (% of GDP)
60
60
1971
Interest rate and inflation (%)
India: Money (M3 in Sept.)/GDP,
Deposit Rate and Inflation
E C O N O M I C G ROW T H I N T H E 1 9 9 0 s
212
with members of the public, many of whom had
lost their savings and pensions in inflation and
repressed financial systems.13 But foreign currency
loans were also popular with borrowers.14
The reforms reduced the burden on banks,
widening their discretion over the allocation of
resources and lowering required reserves. Now that
governments could raise resources from newly
developing debt markets, they had less need to
require banks to invest in government debt or to
hold low-return reserves with the central bank that
were invested in government debt. In many of the
25 largest developing countries, the average ratio of
reserves to deposits fell over the 1990s (Hanson
2003b). Directed credit requirements were reduced,
interest rates were raised on remaining directed
credits, and nominal market rates fell.
Credit:Absorption of Deposits by
the Public Sector
Bank credit to the private sector grew much less
than bank deposits and other bank liabilities in the
1990s (figure 7.2).
FIGURE 7.2
Changes in the Ratios of Bank Assets and Liabilities Plus
Capital to GDP, 1990s
(averages by country group)
Changes as a
percentage of GDP
20
Liabilities + capital
15
10
5
0
–5
1990–2000
Latin America
7 countries
Increased private
sector credit
1993–2000
East Asia
4 countries
1993–2000
Transition
3 countries
Increased net public
sector and central
bank credit
1990–2000
Africa
10 countries
Increased net
foreign assets
Source: IMF, International Financial Statistics.
Note: Countries covered are the same as in Figure 1. South Asia is excluded because countries in that region do not report private credit or capital separately.
Access to credit expanded less than many
observers hoped after the financial reforms, though
it improved toward the end of the1990s. Panel studies had suggested that financial liberalization would
make more credit available to a wider group of borrowers. (See, for example, Schiantarelli et al. 1994,
and works cited there.) After liberalization there
was some growth, but in practice government and
central bank debt crowded out many borrowers. In
some countries where nonbank intermediaries
(henceforth, nonbanks) grew, they did increase
lending to nontraditional borrowers. But both
banks and nonbanks were hindered by the lack of
information on borrowers and weaknesses in the
legal and judicial systems in the areas of collateral
and creditors’ rights.
Instead of increasing private credit, the rise in
bank deposits over the 1990s tended to be absorbed
by government and central bank debt, and by banks
strengthening their offshore positions. In particular,
in the 25 developing and transition countries with
the largest banking systems, the average ratio of net
government debt to bank deposits rose by more than
60 percent, from about 13 percent in 1993 to about
21 percent in 2000 (Hanson 2003b).15 Similar patterns prevailed in the larger African countries.16
The main reason for the rise in government debt
was postcrisis bank restructurings, involving
replacement of weak private credits, particularly in
Brazil, Indonesia, Jamaica, Mexico, and some
African countries. But growing government deficits
also played a key role in some cases, notably India
and Turkey. In general, the increases in banks’ holdings of government debt reflected rises in the stock
of government debt, rather than any increased
attractiveness of government debt to banks, or
decreased willingness of banks to take risks.17
Banks also increased their net holdings of central bank debt—substantially in some countries—
despite falling reserve requirements. On average in
the 25 developing countries with the largest financial systems, banks’ net holdings of central bank debt
rose by nearly 5 percentage points of GDP over the
1990s (Hanson 2003b). As a monetary policy
instrument, central bank debt had advantages over
F I N A N C I A L L I B E R A L I Z AT I O N : W H AT W E N T R I G H T, W H AT W E N T W RO N G ?
the previous instruments of credit controls on individual banks, changes in reserve requirements, and
variations in central bank lending, which had
tended to limit competition, to affect banks bluntly,
and to affect weak banks heavily. But the use of
central bank debt had costs, in that it crowded out
would-be borrowers. Central banks often sold their
debt to sterilize capital inflows as well as to tighten
money when capital flowed out.18 Central banks
may also have sold debt to mop up some of the liquidity that arose from lowered reserve requirements, or when they needed to fund their own
quasi-fiscal deficits that arose from negative spreads
between their assets and liabilities.
Another reason for the slow growth of private
credit was that banks themselves increased their net
holdings of foreign assets for hedging purposes (see
figure 7.2 above).Those in the largest 25 developing-country markets went from essentially a balanced foreign position in 1990, on average, to net
borrowing of nearly 1 percent of GDP in 1993 and
nearly 3 percent of GDP in 1997, before reverting
to being net holders of foreign assets in 2000 (Hanson 2003b). After 1997, external lenders cut credit
lines, banks wound down their external borrowings, and banks increased their external assets.19
Given the limited growth of private sector
credit, a variable that has been shown to be linked
with economic growth,20 it is not surprising that
the rise in GDP growth associated with the financial (and general) liberalization of the 1990s was less
than hoped for.
However, the story is more complex than the
slow growth of private credit. In the major developing countries, especially in East Asia, the average
growth of private sector credit (especially including
external credits) and of GDP was much faster before
1996 than after. About 1995, some countries began
to experience financial crises. Much of the private
credit extended by banks and nonbanks proved to
be unproductive, in the sense that it became nonperforming before or during the crises. During
bank restructurings, these credits were replaced with
government debt (to ensure depositors were paid);
when eventually executed, the associated collateral
213
was usually worth less than 30 percent of the face
value of the loans, suggesting how unproductive the
growth in private sector credit had been. In the transition countries and African countries the quality of
credit issues was typically more related to the public
sector’s use of the credits.21
Bond and Equity Markets
Government and central bank bond market development was fairly successful in the 1990s. By 2000,
more than 40 developing countries, including all
but one of the 25 with the largest financial systems,
had government bond markets (Del Valle and
Ugolini 2003), and more than 20 had central bank
debt markets. The government bond markets
allowed governments to reduce their reliance on
foreign borrowing. The supply of this debt was
inelastic, but it was attractive to banks for several
reasons: its interest rates had been freed, it carried a
low capital requirement, it was less risky than private debt, and it had liquidity once the markets
became active.
The growth of domestic equity and bond markets contributed to private sector financing in East
Asia and India during the 1990s. In the major East
Asian equity markets, market capitalization
exceeded $20 billion in 2000, having risen 80 percent or more (except in Thailand) since 1990.
Turnover averaged more than 50 percent and listings in the individual countries rose at least 40 percent between 1990 and 2000, to the point where
they all exceeded listings in every Latin American
country except Brazil (Standard and Poor’s 2003).
The Indian market was even more successful in providing resources to a wide group of firms after listing regulations were eased (see box 7.1 above).
Chile’s market also did reasonably well, though its
turnover was low because of the pension funds’
buy-and-hold policies. However, even in these
countries, banks remain the main source of finance.
Elsewhere, equity markets were less successful.
On the seven largest Latin American stock
exchanges, listings have declined since 1997, and on
five of those seven they have declined ever since
214
1990; turnover in all seven is less than 50 percent of
market capitalization (Standard and Poor’s 2003). In
transition countries, equity markets were created as
part of the privatization process,22 often with only
belated recognition of the importance of regulatory
frameworks. Listings declined in most of these markets as some privatized companies were taken off
the market. Market capitalization is less than $20
billion, except in Poland, and the Russian Federation, and turnover exceeds 50 percent only in Hungary (Standard and Poor’s 2003).
Several factors lie behind the slow development
of equity markets in developing and transition
countries. The first is that potential investors are
deterred by the low turnover in these markets (usually much less than 75 percent compared with 85
percent in even the smaller deciles of traded companies on the U.S. NASDAQ) and by low liquidity,
which reflects the small sizes of the listed companies as well as the low turnover (Shah and Thomas
2003). Second, listings on stock exchanges have
been reduced by takeovers of firms by multinational
corporations, and trading has been reduced by the
migration of major firms’ listings to industrialcountry markets. In 2000, companies listed offshore
accounted for about 55 percent of the market capitalization in 15 middle-income countries, and for
27 percent of the market capitalization in 25 lowincome countries; much of the trading in these
stocks also takes place offshore (Claessens, Klingebiel, and Shmuckler 2003). Family firms that could
list often do not, partly because the benefits are not
great, partly because these firms often have privileged access to credit through related banks, and
partly because they fear that dilution of ownership
will reduce their control. Third and more fundamentally, weak institutional factors—poor information, poor treatment of minority shareholders, and
weak regulation of market participants—weaken
the interest of investors, both domestic and foreign,
in many equity markets (Glaesner, Johnson, and
Schleifer 2001; LaPorta, López de Silenes, and
Schleifer 2002b; Black 2001).
The better performance of the East Asian and
Indian markets seems to result more from superior
E C O N O M I C G ROW T H I N T H E 1 9 9 0 s
economic performance than from any obvious institutional advantage. This suggests that in the short
run, equity market growth mainly reflects general
economic performance, which attracts foreign
investors willing to risk sums that are small to them
but large relative to the market. Simply setting up a
market may not add much to growth or allow firms
to raise funding. Over time, however, as institutions
improve, equity markets do seem to contribute to
economic growth (Levine 2003; Levine and Zervos
1998).Another important element in equity market
performance seems to be foreign investor participation (Bekaert, Harvey, and Lundblad 2003).
Private bond markets grew even less than equity
markets in the 1990s. They share the problems of
equity markets as well as having some of their own.
Concerns about potential future macroeconomic
instability have led bond buyers to demand high
returns for committing funds for the long term, and
deterred issues of long-term bonds. Often only
public sector firms issued long-term bonds, and
then only in a few countries, notably in South Asia.
Potential buyers of private bonds were also deterred
by lack of protection in law and in fact for bondholders’ rights, and by the lack of good bankruptcy
legislation and enforcement. Nonetheless, some
private bond markets have developed, for example
in India, and in Mexico, recently, for securitized
housing finance.
External Finance for the Private Sector
Within the private sector in developing countries,
external borrowing grew faster than domestic borrowing in the first part of the 1990s, as large private
companies increasingly drew on external credits. For
example, in 17 of the countries with the largest
financial markets, the ratio of private sector foreign
borrowing (of more than one year’s maturity) to borrowings from domestic banks increased fairly steadily,
from 16.5 percent in 1990 to 27 percent in 1997.23
Short-term borrowing also grew substantially. However, after 1997 these credits slowed in dollar terms.
In the same 17 countries, external credit to the private sector changed little in dollar terms. However,
F I N A N C I A L L I B E R A L I Z AT I O N : W H AT W E N T R I G H T, W H AT W E N T W RO N G ?
the ratio of these credits to domestic credit rose by
50 percent by 2000, reflecting crisis-related devaluations and the removal of private sector credits from
banks in restructurings in these countries.
The external credits to the private sector were
narrowly distributed. They went only to internationally creditworthy borrowers, and four countries
accounted for the bulk of private sector external
borrowing (in dollars) in 2000: Brazil (27 percent),
Mexico (12 percent), Indonesia (9 percent), and
Thailand (7 percent).
Offshore equity sales were another source of capital for many large private companies in the 1990s.
The numerous developing-country companies that
were listed offshore in 2000 largely reflected issues of
global depository rights and American depository
rights during the 1990s. Of course, this source of
capital was also narrowly distributed.
While financial liberalization benefited large,
well-run companies and, indirectly, other borrowers in developing countries, it raised banks’ risks.
The best firms obtained loans and equity finance
offshore at less cost than in the domestic market,
albeit with currency risk.24 This left a larger portion of the limited domestic private credit available
to other borrowers, but it also increased the average
risk in the banks’ loan portfolios. Moreover, banks
in developing and transition countries increased
their net intermediation of external loans up to
1997, especially in East Asia, and they also guaranteed some direct external borrowings by the corporate sector, typically off their balance sheets.
The external borrowings were a major factor in
the East Asian external payments crises and were
also important in other crises of the 1990s. As
external borrowings grew, lenders shortened maturities, creating maturity mismatches for borrowers.
Further, loans made by financial intermediaries
based on their own external borrowing, though
typically matched in terms of currency, entailed
substantial risks when the borrowers lacked an
assured source of foreign exchange. Eventually,
lenders refused to roll over their credits because
they considered the risks too high.This generated
both a banking crisis and a foreign exchange crisis.
215
The resulting sharp devaluations increased debtservicing problems on many foreign currency loans
and led to calls on the guarantees, worsening the
difficulties of firms and banks.
Financial Intermediaries
Most of the impact of financial reforms on the institutional structure of the financial sector was not felt
until the latter half of the 1990s. This limited the
gains from liberalization during the decade and
contributed to crises.
State banks, with their well-known problems
(LaPorta, López de Silanes, and Schleifer 2002a),
decreased in importance only after 1995, and
indeed still dominated many financial systems in
2000 (figure 7.3). The continued large state bank
presence meant that credit allocations changed only
slowly, despite liberalization.The problems of state
banks after liberalization were most obvious in the
transition countries,25 where the banks often simply continued to lend to traditional clients or were
captured by politically powerful groups; as a result,
their loans were unproductive and their already
large portfolios of nonperforming loans increased.
State banks in other countries had similar problems.
The continued dominance of these banks, the associated weakness in credit allocation, and the implied
state guarantees that allowed them to raise increasing deposits despite their high incidence of nonperforming loans, all limited the gains from
liberalization and accounted for a substantial part of
the cost of crises in the 1990s.
Private banks changed gradually with liberalization, entry of foreign banks, and fiercer competition, but their deficiencies also contributed to
unproductive lending and crises.Their credit management skills did not keep pace with changes in
the environment such as the growth of foreign currency operations and the greater competition that
their traditional borrowers were facing in the real
sector. Moreover, many private banks in East Asia
and some Latin American countries were parts of
industrial-financial conglomerates and continued
to provide funding to their increasingly unprofitable
216
E C O N O M I C G ROW T H I N T H E 1 9 9 0 s
FIGURE 7.3
State Ownership in Banking, 1998–2000
[Pls. provide vector
image of
this
map.]
Source: Map Design Unit, World Bank.
industrial partners. State banks that were privatized
to local buyers in weak institutional environments
often suffered similar problems and had to be renationalized.
Foreign banks enlarged their role as new policies
eased restrictions on their entry in the latter half of
the 1990s, particularly in transition countries but also
in Latin America and Africa.26 Their entry increased
competition in banking and cut costs for bank
clients.They competed fiercely for the best clients
and drove down profits on business with them, and
they also competed in lending to small firms.27
A second approach to increasing competition,
taken by a few countries, was to simply allow more
banks, by lowering entry requirements.28 Unfortunately, many of these new banks were “pocket
banks,” capturing deposits to lend to their owners’
businesses and often suffering problems. A third
approach was to allow the growth of nonbank
financial corporations (box 7.3). These intermedi-
aries also often suffered from problems of risky and
connected lending and were often the first to fail
when credit tightened.
Greater competition can also create problems for
banks by cutting their profits (Caprio and Summers
1996; Dooley 2003).Although this problem seems to
be mainly one of adjusting to competition
(Demirgüç-Kunt and Detragiache 1998), it does
force owners to decide whether they should continue costly competition,try to exit,or loot the bank.
Thus regulation and supervision, particularly with
regard to bank intervention and exit, are important
issues when liberalization increases competition.
Regulation, Supervision, and Deposit Insurance
Banking Regulation and Supervision
Improvements in the prudential regulation and
supervision of banks lagged behind the liberalizations of the 1990s and contributed to crises. The
F I N A N C I A L L I B E R A L I Z AT I O N : W H AT W E N T R I G H T, W H AT W E N T W RO N G ?
BOX 7.3
Nonbank Financial Intermediaries
(NBFIs) in the 1990s
N
BFIs such as finance companies,
co-op banks, and nonbank financial corporations exist in many
countries and in the 1990s some of them
were an important factor in private sector
credit and deposit mobilization. For example,
India eased restrictions on nonbank financial
corporations in 1992 and by 1996 their
deposits were equal to more than 5 percent
of broad money (box 7.1 above). In Thailand
and Malaysia, finance companies’ deposit and
credit growth picked up in the early 1990s.
In Latin America, co-op banks and housing
banks in Colombia have been important for
some time. NBFIs usually offered higher
deposit rates and credit in different forms
and to different clients than banks—for
example loans for construction, consumer
credit, and small borrowers. NBFIs also were
often subject to easier regulations on interest rates, reserves, and capital than were
banks, as well as less supervision. However,
NBFIs had a history of periodic crises in Latin
America and East Asia, as for example in
Thailand in the 1980s (Sundararajan and
Balino 1991, 47–48). After 1997, many NBFIs
in India, Malaysia, and Thailand went bankrupt, depositors shifted to banks, and, to
some degree, banks increased their loans to
the former NBFI borrowers.
oversight of banks in developing countries started
from a low base in the 1990s because, during the
period of financial repression, bank supervisors had
focused on compliance with directed credit rules.
International standards for supervision—the 25
Basel Core Principles—were not agreed upon until
September 1997. Countries did enact their own
217
prudential regulations and upgraded supervision,
but implementation—a political as well as a technical issue—often lagged, even after costly crises.
Enforcement was patchy, even of weak regulations
on income recognition, provisioning, capital, and
connected lending, and weak banks continued in
operation. International standards on minimum
bank capital were not set until 1988, in the Basel
agreements between industrial countries for internationally active banks.
The issues in improving regulation and supervision were not just technical but also political. The
crises of the 1990s did engender attempts to
improve regulation and supervision. But even then,
regulations were often not strengthened immediately and forbearance was used to limit the capital
injections that governments otherwise would have
had to make. For example, in East Asia, regulations
on capital, income recognition, and provisioning
lagged behind international standards after the 1997
crisis (Barth, Caprio, and Levine 2001), and actual
capital in many Indonesian and Thai banks was still
well below the Basel standard in 2000.
By letting weak banks overexpand, the poor oversight contributed to the crises of the 1990s. In developing countries, weak banks that were allowed to
continue operations often opted for a high-risk/highreturn lending strategy or, in the worst case, were
looted, as has also occurred in industrial countries.
Market discipline, which might have restrained the
expansion of weak banks, was limited by poor information and implicit or explicit deposit insurance.
Deposit Insurance
Deposit insurance and, in crises, blanket guarantees,
were standard recommendations of many financial
advisors, and formal deposit insurance was initiated
or improved in nearly 40 countries in the 1990s,
mostly in transition and West African countries
(Demirgüç-Kunt and Kane 2002; Demirgüç-Kunt
and Sobaci 2001). In addition, countries such as
Ecuador, Indonesia, Korea, Malaysia, Mexico,Thailand, and Turkey introduced blanket guarantees of
bank liabilities. Deposit insurance and blanket guarantees are mainly attempts to reduce the risk of
E C O N O M I C G ROW T H I N T H E 1 9 9 0 s
218
bank runs. Deposit insurance also has the secondary, consumer protection benefit of protecting
unsophisticated depositors. Governments liked
deposit insurance as it appeared to give benefits yet
had no costs, at least until a crisis arrived. Local private banks, often politically important, liked it
because it improved their competitiveness with
state and foreign banks.
The actual impact of deposit insurance and guarantees has been mixed.The statistical evidence suggests that the gains from deposit insurance depend
on its particular features, its credibility, and the institutional environment (Demirgüç-Kunt and Kane
2002; Demirgüç-Kunt and Detragiache 2002). In
many cases, the insurance created large contingent
guarantees, increased moral hazard, and reduced
market discipline (Demirgüç-Kunt and Kane 2002;
Demirgüç-Kunt and Sobaci 2001; Demirgüç-Kunt
and Huizinga 1999).Large lender-of-last-resort support and blanket guarantees in effect provided
unlimited insurance not only for depositors but for
owners, many of whom looted their banks. They
were particularly ineffective in the context of open
capital markets and political and economic turmoil:
for example in Ecuador (IMF 2004b) and in
Indonesia, liquidity support to banks was almost as
large after the introduction of blanket guarantees as
it was before. One reason may be that as the likelihood increases that the deposit insurance or a blanket guarantee will be used, its cost and credibility
comes into question, and runs on banks and the currency may increase (Dooley 2000).
Various attempts have been made to adjust
deposit insurance so as to reduce moral hazard and
increase market discipline ex ante, but usually
depositor losses have been socialized ex post. For
example, insurance limits have been placed on large
deposits and on deposits carrying the high rates that
are often offered by weak banks, but often the limits have not prevented the insurance from extending to all depositors in a crisis. Another approach
has been to use risk-based deposit insurance premiums, in an attempt to offset the moral hazard and
market discipline problem, but in practice the differentials in premiums have been substantially
smaller than the differentials in bank risk (Laeven
2002a, 2000b, 2000c). This probably reflects the
political power of the local bank owners who benefit most from deposit insurance.
To sum up, the schemes that were introduced
for the support of depositors tended to create large
contingent liabilities and to increase moral hazard
while reducing market discipline.They contributed
to crises and volatility by encouraging the funding
of weak institutions after liberalization. Depositors
and external lenders, expecting to be bailed out of
any problems by a government guarantee, tended to
supply too much funding, particularly to state banks
and well-connected financial-industrial conglomerates. Market discipline, which might have limited
this funding, was negligible, not just because of
weak information but also because of the implicit
and explicit guarantees.
Equity and Bond Market Regulation
Improvements in equity and bond market regulation began in the 1990s and also proved difficult to
implement. Even improving trading rules was difficult because of the difference between the interests
of buyers and sellers, on the one hand, and the shortrun interests of market operators, on the other.Also
difficult to resolve has been the conflict between the
interests of majority and minority shareholders.
Attempts to create markets overnight have had only
limited success not only in cases of limited regulation (Czech Republic), but also where investor protection rules appeared to be reasonably good
(Russia). Regulation in Poland seems to have been
relatively successful, however (Black, Kraakmen, and
Tarassova 2000; Glaesner, Johnson, and Schleifer
2001).As with bank regulation and supervision, the
issues are not merely technical but also political.
Pensions
As described in chapter 6, a major change in pension systems occurred in the 1990s, with many
countries shifting from pay-as-you-go systems to
systems in which at least part of pension income is
based on full funding for individual accounts. Chile
F I N A N C I A L L I B E R A L I Z AT I O N : W H AT W E N T R I G H T, W H AT W E N T W RO N G ?
Financial Sector Crises
Financial sector and external payments crises were
features of the 1990s.29 Costly crises occurred in
Mexico, the East Asian “Miracle” countries, Russia,
Brazil, and some Eastern European and African
countries. The new millennium began with crises
starting in Argentina and Turkey and high nonperforming loans in China. Africa also suffered costly
financial crises (figure 7.4).
FIGURE 7.4
Selected Financial Crises, 1980–99
Estimated starting year and restructuring cost
60
Cost of restructuring
as a percentage of GDP
was the first developing country to adopt this
approach, in 1981.Among the countries with large
financial systems, Argentina, Colombia, Mexico,
and Peru in Latin America, plus Hungary, Poland,
and Thailand, all adopted variants of this system
after 1994 (Fox and Palmer 2001).The new systems
gave individuals much better access to their pensions and held the promise of generating demand
for long-term financial instruments and thereby
stimulating capital markets.
The results were not as good as anticipated.
First, all systems had to cope with the change-over
problem of paying existing pensioners while investing the contributions to the new system into assets.
Without large fiscal surpluses, the change-over generated a large increase in government debt that the
new pension system had to hold, as occurred in
Argentina. As a result, the demand for long-term
private instruments did not rise much.Thus the initial impact of pension reforms was simply to make
the government’s liability transparent. A second
issue is that because capital markets typically are
small, pension funds either generated price rises, as
happened even in Chile, and/or had to invest in
bank debt, as happened in Peru. Third, costs have
been high in many of the private pension funds,
reflecting set-up costs, insurance linked to the pensions, and a response to advertising that encouraged
excessive shifts between funds. Some of these problems could have been reduced and country risk
decreased for the individual accounts by allowing
the funds to invest externally, but countries have
usually tried to retain pension contributions and
avoid possible balance of payments pressures.
219
50
INDO
AR
IM
CHK
40
TH
UR
30
Cdl
VEN
20
PH
10
0
1975
1980
SG
1985
1990
KO
BR
BU
EC
MX
TK
CZ MY
1995
2000
Source: Caprio et al. 2003.
Note: The figure illustrates the estimated financial costs of restructuring after selected
crises, but not the losses in GDP.
What role did financial liberalization play in the
financial and currency crises of the 1990s, dubbed
the “twin crises” by Kaminsky and Reinhart
(1999)? The discussion below first assesses the roles
played by macroeconomic problems, financial liberalization, and weak lending by state banks and
financial-industrial conglomerates and then outlines the difficult tradeoffs that policy makers faced
in responding to crises over a short time horizon.
Macroeconomic Problems
Most crisis countries had high debt and larger than
usual current account deficits and were pursuing
exchange rate–based stabilization policies.30 Many
also had open capital accounts, but a causal association with crises is not clear: not all countries with
open capital accounts experienced crises and, in the
1980s, crises had developed even in countries
whose capital accounts were nominally closed.
The combination of high debt and exchange
rate–based stabilization seems to be associated with
unsustainable booms in capital inflows, imports, and
GDP and shifts in relative prices, followed by reversals in these variables as financing slows and maturities shorten, while interest rates rise.The slowing
of inflows reflects both the inherent characteristics
220
of portfolio adjustment and the growth of investor
concerns regarding debt-servicing capacity and
exchange rate pegs.31 The rises in interest rates may
reflect a combination of smaller inflows, growing
concerns about the sustainability of the exchange
rate peg, and attempts to defend the peg with tight
money, often for long periods. Eventually, the
exchange rate depreciates and debts need to be
restructured. Not surprisingly, the financial sector
suffers a crisis in the downward phase of such
cycles, reflecting liquidity squeezes on banks that
have borrowed externally; problems with borrowers, especially those indebted in foreign currency;
and runs on the banks to speculate on the currency.
Various events may trigger a crisis. External
shocks include deteriorating terms of trade,
increases in international interest rates, and increases
in risk premiums in industrial-country markets that
automatically affect developing-country debt.32
Contagion in financial markets has also been
cited.33 Domestically, unstable or inconsistent
macroeconomic policies sooner or later lead to
pressures against banks and the currency. Political
developments, such as the ouster of presidents Marcos in the Philippines in 1986 and Soeharto in
Indonesia in 1998, lead connected parties to liquidate their assets, putting pressure on banks and
lenders with whom they did business.
Financial Sector Liberalization
Financial sector liberalization seems to have been a
factor in crises (Demirgüç-Kunt and Detragiache
1998, 2001; Kaminsky and Reinhart 1999). It
increased capital inflows and deposits, which
allowed rapid growth in credit to weak public and
private enterprises and the government, as well as
to real estate. Over time, the quality of the lending
deteriorated. This may be one explanation for the
lags between liberalization and financial crises
(Demirgüç-Kunt and Detragiache 2001), and
between financial crises and currency crises
(Kaminsky and Reinhart 1999).34 Eventually, corporate bankruptcies, banking problems, and runs on
banks and currencies developed, particularly when
the rapid credit growth and inflows slowed, real
E C O N O M I C G ROW T H I N T H E 1 9 9 0 s
growth declined, and real interest rates rose.35 These
problems were often connected to unsustainable
fiscal policy and the defense of unsustainable currency pegs with long periods of high interest rates.
Problems in the timing and sequencing of liberalization, sometimes related to political issues, also
contributed to the crises (box 7.4).
In assessing the role of financial liberalization in
the 1990s crises, an important question is why
international lenders and domestic depositors supplied so much funding. Part of the large increases in
loanable funds may have reflected a natural overshooting tendency in financial markets (Kindleberger 2000; Minsky 1992). But any such tendency
was certainly exaggerated by the explicit and
implicit guarantees that governments provided to
lenders. Government debt was directly guaranteed
(although after crises it was sometimes restructured). Growing private external debt, funneled
through banks or guaranteed by them, and growing
deposits carried at least an implicit guarantee, which
ex post often became explicit. Moreover, when liberalization led banks to lose franchise value and capital, weak regulation and supervision did not
prevent bank owners from engaging in highrisk/high-return lending or even looting. Nor did
it limit banks’ overexposure to related borrowers.
Thus market discipline was eroded by government
guarantees, implicit or explicit, while weak regulation and supervision did not limit moral hazard.
Guarantees and their credibility may also explain
why the crises in the 1990s seem to have happened
relatively quickly (Dooley 2000). According to this
explanation, avoiding a crisis depends on maintaining foreign investors’ and depositors’ perceptions
that the guarantees (and the exchange rate peg) are
credible. Events, including fears of political change,
can quickly change these perceptions, leading to
shifts into foreign exchange, curtailment of shortterm credits, and rollovers of maturing loans, triggering banking and exchange rate crises.36
Weak Lending
A third factor in the 1990s crises was the weak lending, old and new, by the old financial intermediaries,
F I N A N C I A L L I B E R A L I Z AT I O N : W H AT W E N T R I G H T, W H AT W E N T W RO N G ?
221
BOX 7.4
Problems with the Process of Financial Liberalization
I
n the late 1980s Nigeria liberalized interest rates
and bank entry but retained a multiple exchange
rate regime that was accessible only through banks.
This raised the demand for bank licenses, many of which
went to well-connected parties who were interested in
arbitraging foreign exchange between the multiple
rates, not in banking. Though the number of banks
tripled, the ratio of deposits and credit to GDP fell, and,
by the 1990s, banks were experiencing significant distress (Lewis and Stein 2002).
In Korea, the de facto rapid liberalization of shortterm borrowings in the early 1990s, both internationally
and internally, led the heavily leveraged corporations to
be increasingly financed by short-term inflows and
through less regulated intermediaries. In the run-up to
joining OECD, Korea had opened its capital account by
freeing short-term foreign borrowings, but left longerterm borrowings subject to restrictions in an attempt to
limit total capital inflows (Cho 2001). This policy
encouraged a maturity mismatch in lending and a currency mismatch on the part of borrowers, especially
since rates were much lower on foreign currency loans
than domestic ones. Although deposit rates were formally liberalized in 1993, their rise was limited by moral
suasion, government guidance, and high reserve requirements until 1996. New intermediaries (finance companies converted to merchant banks) sprang up to meet
notably state banks and industrial-financial conglomerates. Before liberalization these intermediaries had large overhangs of bad debt, which had
been rolled over several times to favored borrowers.
Financial liberalization made these debts worse
because of higher real interest rates and lower inflation. Moreover, lower protection and increased
competition reduced traditional borrowers’ ability
to service their debts. However, the increased
deposits and capital inflows associated with financial
reform provided new funds that enabled the banks
demands for funds by intermediating external inflows.
Bank trust accounts were liberalized and grew relative
to bank deposits; they also were allowed to take shortterm commercial paper, which had relatively free interest rates. Finally, the freeing of interest rates on
consumer loans contributed to a shift of loanable funds
to these activities and may have dampened Korea’s saving rate, augmenting the country’s increased reliance on
(short-term) external borrowing.
Thailand set up its “offshore”/onshore Bangkok
International Banking Facility in 1993 with tax and
regulatory advantages that were justified as an attempt
to create a regional financial center operated by
national banks. The facility allowed locals to deposit in
foreign currency and local borrowers to escape (albeit
with short-term loans) from the government’s tight
money policy and foreign currency–denominated loans.
Its operations became a major factor in the expansion
of Thailand’s external debt (Bordo et al. 2001; Alba,
Hernandez, and Klingebiel 1999). Pressure on the government from these borrowers was probably a factor in
the government’s lengthy, costly attempt to defend the
baht even as it supported the borrowers, taking a monetary stance inconsistent with the fixed exchange rate.
After the devaluation, these obligations were a major
factor in the banks’ problems and in the closure of many
finance companies.
to roll over their loans again, adding to the ultimate
volume of nonperforming loans. For example, in the
early stages of liberalization in the transition countries, “most state banks continued to lend as
instructed or for patronage purposes” (Sherif, Borish, and Gross 2003, 21). In East Asia, banks
expanded their lending to related industrial conglomerates, which were increasingly overleveraged
(Claessens, Djankov, and Lang 1998). In addition,
crises tended to generate a shift of deposits to state
banks, because of expectations of government guar-
E C O N O M I C G ROW T H I N T H E 1 9 9 0 s
222
antees.37 This allowed further increases in lending to
favored clients who often used the loans to buy foreign exchange and then defaulted on the loans.
The overhang and growth of state banks’ nonperforming loans, and their cleanup, were substantial
elements in the crises of the 1990s.A notable example is Indonesia (box 7.5). In Thailand, more than 80
percent of Bank Krung Thai’s loans became nonperforming. Brazil’s BANESPA (the state bank of Sao
Paulo) was estimated to have more than 90 percent
nonperforming loans; the estimated cost of the federal government’s 1997 cleanup, prior to privatizing
the bank, was about $20 billion or nearly 3 percent
of GDP. The Finance Ministry has estimated that
restructuring Banco do Brasil and Caixa Economica
Federal may cost $50 billion. In Argentina, the bankrupt state of the smaller provincial banks was
exposed by the spillover of Mexico’s “Tequila” Cri-
sis; the support needed for their privatization
amounted to about half their assets (Clarke and Cull
1999). In Eastern Europe, the cost of the public sector banks’ bad debt overhang was enormous—for
example about 16 percent of GDP in Bulgaria and
about 18 percent of GDP in the Czech Republic
(Sherif, Borish, and Gross 2003). In China, official
estimates of the nonperforming loans of the four
largest state banks exceeded 20 percent of loans in
2003; various private estimates were much higher.
Privatization is often considered as a remedy for
the weak lending of public sector banks, but it has
been costly in cases where the state has retained a
controlling interest or where sales have been made
to weak owners whose operations were poorly regulated and supervised. Mexico’s 1991 privatization
is perhaps the best known example. Soon after privatization, partly because of the currency crisis, the
BOX 7.5
Indonesia: Early Liberalization and Weaknesses Related to Political Connections
I
n Indonesia the freeing of interest rates and easing
of capital and reserve requirements contributed to
large deposit growth, as well as a doubling of the
number of commercial banks (Hanson 2001). By 1996,
competition and the expansion of 10 private banks had
reduced state banks to about 45 percent of the system.
However, all banks were very weak (World Bank 1996,
1997a). Despite the rules, state banks were overexposed
to well-connected borrowers, and private banks to their
owners. State banks reported low capital and their
reported nonperforming loans, though high, were understated, given the rollover of bad loans and other maneuvers. At least two state banks were insolvent. Loans
were often inflated by “commissions” to loan officers.
Private banks reported better figures but weak supervision provided no check on them. Exposure limits were
not enforced and many small banks were bankrupt.
The spillover from the July 1997 Thai devaluation
exposed these weaknesses and the dependence of
finance on the political regime. Capital outflow devel-
oped and rollovers of the large amount of short-term
external loans stopped as investor concerns mounted
(despite the imposition of limits on currency speculation). Monetary policy was loosened to ease borrowers’
problems. The November IMF program brought little
relief—runs on private banks and the currency speeded
up with the closure of 16 banks (small depositors did
not begin to be paid until January 1998) and the
December illness of Soeharto. State banks, which benefited from shifts in deposits, made loans to well-connected borrowers on the basis of projected exports that
did not materialize. In January 1998, outflows
increased with the poor reception of the 1998–99
budget, panic buying of goods, riots that frightened
Indonesians of Chinese origin, and the possibility of
introducing a currency board. The exchange rate fell to
less than one-seventh of its precrisis level. Massive
central bank liquidity support, often well in excess of
banks’ capital and in some cases up to 75 percent of
their assets, would have doubled the money base had
(Box continues on the following page.)
F I N A N C I A L L I B E R A L I Z AT I O N : W H AT W E N T R I G H T, W H AT W E N T W RO N G ?
Mexican government was forced to renationalize
the banks; it then cleaned up their balance sheets at
an estimated cost of more than US$70 billion and
reprivatized them to international banks, beginning
in 1998 (box 7.6).
In Eastern Europe, the initial bank privatizations
went poorly,particularly where governments retained
a controlling interest (Clarke, Cull and Shirley 2003).
In Africa, too, the experience with bank privatization
was often bad, with long delays and sales eventually
made to undercapitalized owners who did not
improve credit management and abandoned the
banks when they lost their capital (box 7.7).
Difficulties in Policy Responses to Crises
The crises presented difficult new policy problems.
Traditional macroeconomic policies of tighter fiscal
and monetary policy and devaluation were appro-
223
priate for reducing excess demand and current
account deficits to financeable levels. But the financial sector problems, and their implications for the
balance of payments, raised a new set of more complicated issues and tradeoffs, for which no single
best practice exists.
To deal with an individual bank’s problems, the
standard recommended response is to provide liquidity support at high interest rates and then intervene with protection for small depositors. But banks
become insolvent well before they become illiquid,
and owners of insolvent banks may then choose a
risky lending strategy or even attempt to loot the
bank (de Juan 2002).38 Moreover, problems in one
bank typically indicate more widespread problems,
and closing a bank without promptly compensating
depositors may trigger runs on other banks and
looting by bank owners.
BOX 7.5
(continued)
reserves not fallen (Kenward 2002; World Bank 2000c).
Imposition of a blanket guarantee at the end of January temporarily slowed outflows. Soeharto’s reelection
in March was followed by severe riots, often directed
against Indonesians of Chinese origin and Soeharto
cronies. Capital outflows rose once again, as did liquidity support. In May 1998 Soeharto resigned but pressures on banks continued.
In sum, liberalization encouraged deposit growth
and foreign inflows, but credit access depended not on
profitability but on political connections, including
access to external loans from international banks (corporations did much of Indonesia’s external debt borrowing; the state banks’ external borrowing was
limited by policy). Lenders and depositors looked at
connections, not at risk and corporate leverage. The
easing of bank licensing and the lack of enforcement
of exposure limits worsened this problem. Then, when
political concerns developed, the well-connected tried
to withdraw their assets and an outflow developed,
exacerbated by the concerns of the middle-class
Indonesian Chinese. As a result, the blanket guarantee
stopped the bank runs only temporarily—total liquidity support was nearly as large after the blanket guarantee was imposed as before, according to the figures
in Enoch et al. (2001). Of the US$20 billion liquidity
support that went mostly to private banks, 96 percent
was unrecoverable and a substantial amount was
diverted into foreign exchange speculation, according
to an ex post study by the National Auditor. The cost
of the crisis is estimated at more than 50 percent of
GDP. Bank Mandiri, a merger of four state banks of
which at least two were bankrupt before the crisis
began, accounted for about 30 percent of the cost of
the crisis (more than 17 percent of GDP). More than 70
percent of the losses in the state banks were in loans
that had to be taken off the books. The poor quality of
these loans is shown by the eventual recovery rate of
less than 30 percent, most of which was realized four
to five years after the crisis.
E C O N O M I C G ROW T H I N T H E 1 9 9 0 s
224
BOX 7.6
Bank Privatization in Mexico
M
exico nationalized its commercial banks in
1982. It decided to privatize them in 1991,
as part of liberalization and to raise fiscal
resources. At the time, the privatization was acclaimed
as a resounding success, fetching higher prices than
predicted. Although open only to domestic purchasers,
the sale was considered technically well designed and
executed. Bidders were first qualified, and the auctions
were transparent and quick, without scandal.
The macroeconomic (Tequila) crisis of 1995 took the
shine off this success: loan defaults increased sharply
with the collapse of the peso and the rise in interest
rates. Failing banks were found to have made poor loans
under the relaxed regulatory framework, often to politically powerful groups connected to their controlling
owners (Haber and Kantor 2003; LaPorta and López de
Silanes 2003). The connected lending meant that the
banks had effectively financed much of their own purchase. Taking into account loans from development
banks, the buyers actually had minimal equity, but this
had not prevented their purchase of the banks. The government renationalized the failed banks and protected
the depositors but taxpayers were left with a huge bill,
estimated at 18 percent of GDP.
The features of the sale that were praised earlier are
now often criticized: the privatization for being too hasty
and the purchase prices as too high. Yet a sale was considered necessary to raise fiscal resources and sustain the
government’s commitment to reform. The main mistakes
were the exclusion of foreigners and the acceptance of
purchases by politically powerful but heavily leveraged
buyers. The exclusion of foreign bidders was partly a calculated risk to shore up domestic support in a nationalistic country. Even with foreign participation, highly
leveraged locals might have bid more for the banks
through their access to loans. Thus, above all, the Mexican
experience illustrates not just a flawed privatization but
the complicated issues that bank privatizers must juggle,
including the difficult problems associated with dealing
with local elites in a sector as sensitive as banking.
As a bank problem becomes systemic, bank runs
turn into currency runs and pose severe problems
for which there is no standard answer.The government faces the unpleasant choice of either intervening in weak banks, thus possibly provoking runs
on other banks,39 or providing liquidity support—
loose money—that will spill over into pressure on
the exchange rate and international reserves, especially in open economies (World Bank 2000c).
Another choice is that of how much to support
the exchange rate with reserves and tight money
(offsetting the loose money from liquidity support)
versus how much to allow a depreciation. Tight
money helps to protect the exchange rate, as in the
traditional policy response, and thus helps borrowers in foreign currency, but it hurts borrowers in
local currency and it hurts banks, particularly if it is
maintained for a long time. Liquidity support and
loose money will help borrowers in local currency,
but put additional pressure on the exchange rate
that will hurt borrowers in foreign currency. Use of
reserves delays this problem, but reserves are finite
and their decline can provoke a speculative attack
on the currency.
Nontraditional policies have had only mixed
success. Capital controls have not been effective in
stopping currency runs.40 A blanket guarantee may
or may not halt bank or currency runs, depending
on how it affects concerns about the credibility of
the guarantee and the burden of future costs (Dooley 2000).A few countries, including Argentina and
Ecuador, have tried to stop bank runs by freezing
deposits and devaluing, but the disruption to the
payments chain has led to massive recessions. If
deposits are to be written down, in parallel with
loans, it is probably best to make a politically
F I N A N C I A L L I B E R A L I Z AT I O N : W H AT W E N T R I G H T, W H AT W E N T W RO N G ?
225
BOX 7.7
Bank Restructuring and Privatization in Sub-Saharan Africa
A
t the end of the 1980s many African banks were
insolvent and illiquid. Governments undertook
major restructuring programs over the 1990s to
deal with these problems. A gradual return to macro-stability and balanced government budgets—a prerequisite
for bank restructuring—occurred in programs supported
by the International Monetary Fund (IMF) and the World
Bank. Directed credits were abandoned and interest rates
liberalized. Government arrears to the banking sector
were often securitized on various terms, with debt service often guaranteed. Money markets were established.
Many countries issued new banking laws, overhauled regulations, and set up supervisory authorities.
Bank restructurings were both organizational and
financial and sometimes led to privatization, but the
process also often required multiple restructurings and
was hesitant (World Bank 2001, box 3.3). Some banks,
particularly public sector banks, were closed or weak
branches were turned into agencies. In Benin, the
extreme case, all public sector banks were closed in
1990, leaving the country without banks for some
months until new private banks entered the market. In
other cases, bad assets were provisioned and losses were
absorbed by existing shareholders (governments and the
private sector); in a few cases, new capital was injected
by the private sector; and in others, bad loans were
removed from banks. Asset recovery corporations were
set up to manage bank liquidations and/or to recover
loans and reimburse depositors/creditors (for example in
Cameroon, Côte d’Ivoire, Ghana, Uganda, and Senegal)
with mixed results. Management was changed, staff
retrenched, internal controls were put in place, and new
loan procedures were gradually developed.
Treatment of depositors in failed banks varied from
country to country. In some, the government left the
deposits in the restructured bank or reimbursed all
depositors. In others, repayment of depositors
depended on the asset recovery of the failed institutions. Priority was given to compensation for small
depositors. Depositors incurred substantial losses in
Cameroon and the Republic of Congo, for example.
Some countries introduced deposit insurance in the late
1990s, but it is unclear whether these systems could
handle banking crises as large as those of the 1990s.
Privatizations generally went to a major institutional partner, often foreign. In some cases the foreign
banks were large and well known, with a reputation to
protect. African private banks that operate in several
countries have developed (Ecobank, Bank of Africa,
Financial Bank, CBC, Stanbic) as a result of privatization involving foreign partners. However, in some
cases, the foreign banks provided little improvement.
As a result of the restructurings, African commercial
banks have become more solvent, liquid, and profitable
and a safer haven for deposits, but many problems
remain. In many countries, banks are still weak in their
lending and operations. Bank deposits have declined in
some countries, probably reflecting a mix of bank closures, discouragement of small deposits, and civil
strife. Commercial bank lending has generally been limited, reflecting crowding out of government debt and
bankers’ selectivity in lending.
Source: World Bank 2001, box 3.3.
unpalatable exchange of tradable bonds, as
Argentina did in its January 1990 Bonex plan.
Whatever is done, GDP growth is almost certain to
slow if not decline (Frankel and Wei 2004).
In sum, the crises of the 1990s appear to be
related to macroeconomic problems, but also to
financial liberalization in the context of the overhang of old political and economic relationships,
manifested in state banks and politically powerful
financial-industrial conglomerates. Government
guarantees encouraged a rise of funding for these
intermediaries, which they channeled into weak
226
loans. Eventually crises developed and the depositors and external creditors were bailed out by governments. Privatization in these environments did
not solve the problems, and often required costly
renationalizations.
3. Lessons of the 1990s
In the 1980s and 1990s the approach to finance
shifted from the repression of prices and markets
and the use of government credit allocations to a
more market-based, internationally open system.
Yet this shift, along with the other reforms, had less
than the expected effects on growth. Access to
financial services does not seem to have improved
substantially in the 1990s, though there are indications of improvements recently. Expectations may
well have been too high. Another reason was an
apparent “boom in bust[s]” (Caprio 1997), related
to macroeconomic policies but also to financial liberalization in the context of an overhang of weak
institutions—financial intermediaries, financial
markets, and informational, legal, and judicial
frameworks. Problems in these areas reduced the
impact of liberalization and in some cases led to
perverse results.
The weaknesses of institutions were not just a
technical issue: they reflected the difficulty of changing the previous state-led development system and,
more fundamentally, its underlying political-economic basis within a short period, while restraints
on markets could be and were quickly lifted. The
overhang of these factors during the 1990s was an
important reason behind the following:
• Credit allocation was weak and continued to go
to the public sector, well-connected individuals,
financial-industrial conglomerates, and traditional state bank clients.
• Bank privatization was slow and partial privatizations left control of intermediaries in the hands of
government in many transition and African
economies,leading to continued preferential treatment of the traditional borrowers from state banks.
E C O N O M I C G ROW T H I N T H E 1 9 9 0 s
• Privatizations and restrictions on foreign entry
in the financial sector often allowed local elites
to retain or increase their economic and political
power.
• Implicit and explicit guarantees of deposits and
international loans supported local elites’ ability
to raise resources.
• Liberalization of bank licensing led to “pocket”
banks that mainly engaged in connected lending
or regulatory arbitrage, not expansion of access
(the record of nonbank intermediaries is somewhat better but they too were often linked to
industrial-financial conglomerates).
• Development of the framework for capital markets—such as reasonable information, legal and
judicial treatment of bankruptcy, treatment of
minority shareholders, conduct rules for market
participants—was slow, compounding the problems that capital markets in developing countries face in terms of concerns about
macroeconomic stability, high costs, and low liquidity.
The process of liberalization and the limited
nature of the results in the 1990s suggest four major
lessons, discussed next.
Finance Depends on Institutions
Perhaps the most important lesson of the 1990s for
finance is that the financial sector’s contribution to
development depends not just on resource mobilization but also on attention to institutions: intermediaries, markets, and the informational,
regulatory, legal, and judicial framework. Resources
need to be allocated to those that offer the best combination of return and risk, and this depends on the
quality of institutions. Building up these institutions
is not easy, takes time, and requires political support.
In the 1990s, the traditionally weak loans of state
banks and financial institutions linked to industrial
conglomerates were further weakened by the
higher interest rates that followed liberalization, as
well as by increased import competition and real
appreciations that cut the profitability of traditional
F I N A N C I A L L I B E R A L I Z AT I O N : W H AT W E N T R I G H T, W H AT W E N T W RO N G ?
borrowers. Explicit and implicit guarantees allowed
these financial institutions to obtain much of the
liberalization-induced increase in deposits and capital inflows, and to substantially expand lending to
their traditional borrowers,private and public.Regulation and supervision did not prevent this; their
weaknesses reflected not just technical but political
issues. Market discipline was eroded by poor information and, more important, by implicit and
explicit guarantees. Better capital market development could have relieved some risks and absorbed
part of the shocks. However, the capital markets
faced competition from implicitly or explicitly
guaranteed deposits and external loans. Market
development also was hindered by the inherent
problems of capital markets in developing countries
and the difficulties of building up a reasonable institutional framework quickly.
By the end of the 1990s, it became clear that
much of the increased deposits and capital inflows
had gone into (1) unproductive private borrowing
or state enterprise debt that had to be replaced by
government debt in order to bail out depositors
and lenders, (2) deficit finance, and (3) central bank
debt to stabilize the economy. Thus it is not surprising that the financial liberalizations of the 1990s
did not live up to the high expectations regarding
sustained increases in growth or credit access.
Focusing on the poor quality of credits exposes
a common thread in the slow growth and financial
crises of the 1990s: the continuation of preferential
access, related to the overhang of old institutions,
that was changed only slowly by the financial
reforms. In many countries in the 1980s and 1990s,
public sector borrowing, with its implicit guarantee
from future tax revenues, was excessive and eventually led to crises and slow growth. But even in
countries with smaller public sectors and relatively
limited fiscal problems, such as Chile in the late
1970s and East Asian countries in the 1990s, loans
to industrial conglomerates—made from the guaranteed deposits in the private financial intermediaries that they controlled or from state banks and
international lenders, to which they had preferential access because of the institutional set-up—
227
eventually became nonperforming and contributed
to crises. As noted earlier, the poor contribution of
such loans to sustained growth is shown by the low
value of the associated collateral when it was eventually sold.
Delaying Needed Policies Is Costly
Limiting the incidence and cost of financial crises
depends on resisting political pressures to prolong
unsustainable booms and to delay action on weak
banks,41 as well as on avoiding socializing their
losses. In the 1990s, governments often tried to prolong booms and did not limit the expansion of
weak banks.42 Unfortunately, such policies
increased the ultimate volume of bad loans and the
size of the crises. Then, after crises occurred, governments typically responded by bailing out depositors and external investors through liquidity
support, expansion of whatever deposit insurance
existed, and blanket guarantees, all of which generated large increases in government debt and contingent liabilities.
Expectations that losses would be socialized,
through explicit and implicit guarantees, also contributed to crises and volatility by encouraging
weak institutions to mobilize funds after liberalization. Depositors and external lenders, expecting to
be bailed out of problems by a government guarantee, supplied funding to state banks and financial
intermediaries that were part of financial-industrial
conglomerates. The funding was well in excess of
what could be used productively. Market discipline,
which might have limited this funding, was weakened by the implicit and explicit guarantees.43 The
process was unstable, however.When a rise occurred
in the subjective probability that the guarantees
would be called, net capital outflows developed, as
depositors and investors became concerned about
how the guarantees would be paid and funded.44
The capital flight was facilitated by the liquidity
support to weak banks and the support of the
exchange rate by reserve sales.The combination of
high initial returns, limited losses on the funds that
were taken out of the countries just before the
crises, and the ultimate provision of government
228
guarantees left the depositors and investors with
good returns during the 1990s.45
Improvements in these policies will depend not
just on new measures but also on strong implementation, which has been difficult even in industrial
countries.
Financial Liberalization Increases Financial
Resources
A financially liberalized economy tends to generate
more financial resources than a repressed economy.
This is an old lesson (McKinnon 1973; Shaw 1973)
that had been forgotten during the financially
repressed 1980s. During the 1990s, the growth in
bank deposits (relative to GDP) speeded up in many
countries. This acceleration reflected lower inflation, more realistic interest rates, and a wider menu
of financial instruments, including foreign
exchange–denominated instruments. In addition,
domestic capital markets were started and developed and private firms increased their external borrowing and external equity issues.
Deposits and domestic capital markets performed best where growth was already rapid, where
there was a history of high deposit mobilization, and
where investors were willing to take risks to get
equity shares in rapidly growing corporations: East
Asia and India. Elsewhere, deposit growth was less
and capital market performance was less good.
Deposit growth picked up much less in Latin America, reflecting the region’s history of inflation and
government intervention.Also, much of the growth
was in foreign currency deposits that complicated
policy making.The decline in listings in equity markets in Latin American and transition economies
suggests that access to finance through equity issues
did not widen much. Even where capital market
performance was better,access suffered from the lack
of scale and liquidity in the markets; multinational
takeovers of major firms; migration of listings to less
costly, more liquid industrial country markets; and,
more fundamentally, weak institutional frameworks—in particular the lack of information, regulatory protection of minority shareholders, and
bankruptcy protection for bond holders. Private
E C O N O M I C G ROW T H I N T H E 1 9 9 0 s
external borrowing and offshore equity issues did
provide lower-cost funding but only to larger corporations in a few countries, and the loans were subject to currency and rollover risk.The slowdown in
net private-to-private disbursements and short-term
loans was a major factor in the crises.Though it will
be difficult, better development of domestic capital
markets, even in the countries that have done relatively well, would reduce the impact of future crises.
Successful Finance Depends on Macroeconomic
Stability
Another old lesson is that successful financial liberalization and successful finance depend on macroeconomic stability (World Bank, World Development
Report 1989). If anything, open capital accounts and
volatile international capital flows place a larger premium on sound macroeconomic management.
However, financial reforms, or at least more market-based interest rates, were often put in place in
the 1990s in the midst of macroeconomic imbalances, complicating what was already a technically
difficult problem.46 For example, countries with
unsustainable fiscal policies often used financial liberalization to continue their debt buildup and delay
adjustment.47 Even when fiscal deficits were smaller
than in the 1980s, the countries that liberalized
finance often had large external and internal debt
overhangs that contributed to volatility.
Even a strong financial system has difficulty protecting itself against default by an overindebted
government, as the recent Argentine crisis illustrates.48 Also, many countries that liberalized were
pursuing exchange rate–based stabilization, or had
relatively fixed exchange rates. These macroeconomic policies, and the tight monetary policy and
the credibility issues associated with them, often
meant extended periods of high real interest rates
and burdensome external borrowing, which eventually contributed to countries’ inability to service
debt and to financial crises.Thus, the problems with
financial liberalization, the crises, and the limited
results from financial liberalization in the 1990s
often reflected macroeconomic policy deficiencies
and the overhang of large external debts.
F I N A N C I A L L I B E R A L I Z AT I O N : W H AT W E N T R I G H T, W H AT W E N T W RO N G ?
4. The Future of Finance
Looking ahead, the general pattern seems likely to
remain one of more market-based finance. In most
countries the financial liberalizations of the 1990s
are unlikely to be reversed in their broad aspects,
barring large macroeconomic policy errors. A
widespread return to financial repression is probably now untenable for two reasons. One reason is
political: lower inflation and a more market-based,
more open financial system became political
imperatives in the 1990s. Repressed finance had
high costs and regressive distributional effects. Over
time, increasingly politically active households have
demanded protection for their savings and access to
the investment opportunities that were once available only to political and economic elites.A second
reason, noted earlier, is that the increased access to
external financial markets brought about by the
enormous growth in trade, travel, and migration
and by improvements in communications has made
financial repression difficult.49
Although macroeconomic stability, on which
good finance depends, seems to exist in many countries, macroeconomic issues remain. First, in today’s
open economies, slow policy responses or policy
errors quickly translate into macroeconomic instability. Second, large government debt overhangs
and/or large unfunded pension liabilities are problems in many countries.The burden of these problems has been eased by low world interest rates, but
rising world interest rates, as well as other shocks,
may lead macroeconomic policy astray.As the 1980s
and 1990s show, excessive government debt can
interact with inconsistent exchange rate and monetary policy to lead to massive capital flight, large currency depreciations, and costly financial sector
collapses.When the government goes bankrupt, the
financial system and the whole economy suffer.
The financial liberalizations of the 1990s have
created a sounder basis for finance in at least six
ways:
• Crises cleared away the “debris” of past nonperforming loans, although they left large holdings
of government debt that created problems.
229
• Intermediaries and capital markets have
improved. In Eastern Europe, Latin America,
Africa, and even East Asia, many financial intermediaries were gradually replaced by reputable
foreign banks. Such banks have better lending
skills, are more able to engage in arms-length
lending and resist government pressures, and,
potentially, impose fewer demands on government for bailouts than the intermediaries they
replaced. Capital markets have also been set up
or improved, but they still face many structural
and institutional challenges.
• Government and central bank debt markets have
developed.They allow central banks to carry out
monetary policy more efficiently, increase banks’
liquidity, and allow less inflationary finance of
fiscal deficits. The growth of government debt
markets also helps provide a benchmark that can
make private debt markets more efficient.
• Access to credit is growing in some countries,from
foreign banks (Clarke et al. 2004), new domestic
banks, and bank-like intermediaries.With the closure of the old intermediaries,bad credit no longer
drove out good credit. New intermediaries that
hold the promise of a sustainable increase in smallscale lending were able to grow. In Ecuador, for
example,the collapse of the public sector intermediaries has left room for dramatic growth in private banks’ small credits in the last two years.
• Information is improving. The accounting and
auditing of intermediaries and borrowers is
improving.So is information on small borrowers—
public credit bureaus have been established in 23
(mostly transition countries) since 1994 and the
private credit bureaus that already existed in many
countries are improving (World Bank 2003d).
• Prudential regulation and supervision seem to
be improving and, in a few cases, the combination of regulation, supervision, and a better safety
net have limited the impact of crises in individual banks, for instance in Peru, although supervision has also missed major weaknesses in some
countries, such as the Dominican Republic.
230
Improving Finance
Further improvements in the contribution of
finance to development depend on improving the
key tradeoff between safe and sound finance and
risk taking in the financial sector’s intermediation
between savers and investors.The crises of the 1990s
naturally have raised concerns about financial instability that can lead to poor growth. Governments,
attempting to reduce the future costs of crises, have
often tended to emphasize prudence. But there is a
tension between stability and the ability of the
financial system to carry out the key intermediary
roles for development—mobilizing funds from
savers, allocating these funds to investors that will
yield the best combination of return and risk,
reducing risk, and shifting risk to those most willing to bear it.A financial system that does these tasks
well will contribute greatly to development.
Improving the tradeoff between stability and
intermediation in finance depends not just on
maintaining the systems of market-based interest
rates and credit allocations that arose during the
1990s, but also on the following:
• Reducing the crowding out of private credit by
the current large overhang of government debt;
• Reducing the volatility of resource flows, particularly on the upside of cycles and to weak institutions;
• Improving intermediaries and markets; and
• Widening access to credit.
The discussion below addresses each in turn.
Progress will depend heavily on countries’ success
in building institutions, improving their informational and legal frameworks, and, ultimately, achieving more competitive political systems that will
reduce the power of political-economic elites.
Reducing the Crowding out of Private Credit
Perhaps the most immediate obstacle to the ability
of the financial system to carry out its intermediary
role, as well as a threat to stability, is the large overhang of government debt in many countries.50 It is
E C O N O M I C G ROW T H I N T H E 1 9 9 0 s
often said that private credit is currently limited by
the unwillingness of banks and markets to take
risks. In fact, it is limited by the large volume of
inelastically supplied government debt. This is
because, to ensure that all government debt is held
(either by financial intermediaries or by individuals), the spread between interest rates on government debt and private debt has to be big enough to
crowd out enough private debt. Hence the way to
expand the supply of private credit is not to try to
make government debt less attractive but to leave
more space for funds for the private sector in the
financial system, or to make private debt and equity
more attractive, so that more financial resources can
be raised in total.
Reducing the Volatility of Flows and Its Impact
Governments have made various efforts to reduce
the volatility of flows, especially on the upside of a
boom, and to ease the impact of volatility, particularly by building up international reserves to offset
shocks and, within banks, by externally hedging
foreign currency liabilities.
But much remains to be done. Some analysts
have argued for reducing incentives to excessive
capital inflows that can easily turn into excessive
outflows.They argue, for example, that India’s success in avoiding the 1997 crisis was related to its
limits on banks’ (and firms’) offshore borrowing,
even as it allowed inflows into the stock market and
liberalized direct foreign investment regulations.
Chile’s implicit taxes on short-term inflows also
appear to have had some success in reducing
inflows, extending their maturities, and in limiting
the impact of shocks, but at the cost of reducing
credit availability to the private sector (Edwards
1999; Forbes 2003).
Another approach would be to reduce the
incentives to banks for increasing their net offshore
borrowings.This would involve at least leveling the
playing field through application of the same
reserve, liquidity, directed credit requirements, and
premiums for “deposit insurance” as on domestic
deposits. Here, too, little has been done. In the area
of international bond issues, some countries have
F I N A N C I A L L I B E R A L I Z AT I O N : W H AT W E N T R I G H T, W H AT W E N T W RO N G ?
begun to try to reduce the bias in bond buyers’
beliefs that any restructuring will favor them, by
making restructurings easier in terms of lowering
the percentage of bond holders that is needed to
accept a restructuring offer (the Collective Action
Clause). However, it remains to be seen how this
change will operate—U.S. courts have often
allowed individual creditors to seek preferential
treatment. In the case of Elliot Associates vs. Peru,
settled in 2000, Elliot Associates obtained a restraining order on the payments on the restructured debt
to which Peru had agreed with other creditor representatives. Peru eventually settled by paying Elliot
Associates $56 million for the debt that they had
bought for $11 million in 1996. Ultimately, all
attempts at limiting excessive inflows depend on
political will to limit a boom, while in practice,
countries often have eased restrictions on capital
inflows in order to prolong a boom.
Internally, governments have tried to develop
capital markets as a shock absorber for the volatility
of external and internal flows. Funds invested in
equity or long-term domestic government and private debt represent much less of a threat to the economy than do volatile short-term external capital
flows.51 Thus, capital market development could
contribute to stability as well as assisting the allocation of funds to promising activities. One problem,
of course, is that investors in such instruments
demand high returns under the current environment in developing countries, so such instruments
are often unattractive to potential issuers.This problem adds to the structural problems of small size,
lack of liquidity, and high costs that limit capital
market development. Domestic capital markets, particularly in the larger countries, could be stimulated
by improvements in institutional factors,such as better information on firms, better rules on market
conduct and corporate treatment of minority shareholders, and better legal and judicial treatment of
bankruptcy. Generally, such improvements require
substantial time and effort.
Better market discipline is another approach to
enhancing both intermediation and stability. Market discipline means ensuring that depositors and
231
international lenders have appropriate incentives to
limit their funding to weak intermediaries, by
ensuring that they stand to receive lower returns on
deposits and investments if problems occur. Market
discipline complements government regulation and
supervision and evidence exists that it can work in
developing countries (Martinez-Peria and
Shmuckler 2001; Calomaris and Powell 2001).
Unfortunately, market discipline depends on good
information. Though accounting and auditing are
improving, much remains to be done. For example,
regulations could encourage prompt dissemination
of accurate information and impose stiff penalties
for failure to do so.
Perhaps more important, market discipline is
blunted by widespread implicit and explicit government guarantees that developed in the 1990s. To
make market discipline work, governments face the
difficult task of establishing credible limits on liquidity support, blanket guarantees, and deposit insurance, so that at least the holders of banks’ large
obligations consider themselves at risk. One way to
begin improving market discipline might be to limit
payoffs to large providers of funds, especially since
the latter can be expected to have relatively good
information about the strength of individual banks.
It would also help to prevent problems in one bank
from contaminating the rest of the system. However,
the policy would immediately pass the problems of
a weak bank on to the central bank as lender of last
resort—a role that also would need to be limited, to
contain costs. Deposit insurance would also come
into play,and would need to be truly limited to small
deposits. Premiums for deposit insurance would
need to reflect differences in risk in different classes
of banks. Unfortunately, the systems of risk-based
premiums that have been adopted have largely
copied the pricing from industrial economies and,
though better than flat, premiums still provide substantial subsidies to domestic private banks, probably
because of the banks’ political power.
When banks’ problems have become more systemic, the past responses—large lender of last resort
support and blanket guarantees—have undermined
future market discipline and been costly to future
232
generations. In effect, they have provided nearly
unlimited insurance not only for depositors but also
for owners who can loot their banks. Alternative
options for dealing with crises would need to begin
with a different approach to dividing the costs of the
crises between current holders of liabilities and
future generations. Lengthy suspensions of deposit
withdrawals have proved to be undesirable: they
break down the payments chain and have contributed to large declines in output, as has happened
in Argentina and Ecuador. But brief suspensions of
deposit withdrawals, while term deposits are replaced
by long-term, marketable instruments that involve a
substantial discount (in present value terms), are a
possible alternative that would make current depositors bear part of the cost of the crisis (Beckerman
1995; IMF 2004b). Of course, such policies are politically difficult to implement. But they would not
only limit the burden of crises that future generations
would have to pay, they might also reduce the size of
future crises, by strengthening market discipline.
To limit weak lending and crises, governments
have also improved their banking laws and prudential
regulation and supervision.Since the strengthening of
prudential regulation and supervision only began in
the later 1990s, not much evidence has accumulated
on how well it can work to prevent crises.At the simplest level, regulators and supervisors in developing
countries may lack the technical skills even to deal
with loan quality and provisioning, not to speak of
more complicated aspects of banking,such as evaluating complex operations in capital markets and foreign
exchange,swaps and derivatives that are poorly valued
in imperfect markets, and risk management models.
Deficiencies exist in the consolidated supervision of
financial-industrial conglomerates and in the supervision of offshore activities—important areas in developing countries that will not be improved simply by
giving supervisors more power.
Partly these problems reflect incentives: typically
supervisors are poorly paid and have an incentive to
shift into banking, especially once they have been
trained to handle tasks well. Often supervisors are
subject to lawsuits by bankers, even for actions in
performance of their duties—which makes them
E C O N O M I C G ROW T H I N T H E 1 9 9 0 s
hesitant to raise issues.52 Protecting supervisors completely from legal action raises another issue—the
risk that they will engage in malfeasance. Hence a
tribunal separate from the court system is needed to
deal with accusations of malfeasance by supervisors.
More fundamentally, improvements in regulation
and supervision face substantial political roadblocks,
which have arisen in industrial as well as developing
countries.For example,from time to time,U.S.financial economists have raised concerns about some
U.S. banks being too big to fail. Also in the U.S.,
political forces and regulatory forbearance are often
cited as a contributory factor in the U.S. savings and
loan crisis. In many developing countries a few large
banks dominate the system, and bankers and major
borrowers are often one and the same. In this context, regulatory capital does not have even the minimal incentives that it does in arms-length
transactions between intermediaries and borrowers.
The industrial-financial groups are the principal
entrepreneurs in many countries, even large ones, so
limits on connected lending are not feasible. If problems of loan quality develop, the strength of the economic and political elite is likely to lead to regulatory
forbearance. Even if supervisors can identify capital
insufficiencies and other regulatory violations, it
would be difficult for them to stand up to monolithic political elites, particularly when the alternative
is simply to ignore a problem in return for a supplement to their small salaries. Finally, the potential
strength of regulation and supervision is limited by
the still-important role of large state banks that carry
out government policies and are nontransparent
almost by design. In sum, regulation may not be successful unless it also empowers the market to monitor banks better, by encouraging market discipline.
Improving Intermediaries
The entry of reputable foreign banks is one way to
improve intermediation as well as to limit the cost
of crises. Reputable foreign banks bring better
trained staff to the country and generally have better systems for evaluating and managing credit risk
than local banks. These advantages often spill over
into the local banking system, from competitive
F I N A N C I A L L I B E R A L I Z AT I O N : W H AT W E N T R I G H T, W H AT W E N T W RO N G ?
pressures and the movement of personnel. In addition, reputable foreign banks also are likely to cover
any losses on their loans or operations without
demanding government support, so as to avoid
damaging their reputations.
Reputable international banks have entered
many countries in recent years, but losses and, in
some cases, their own lack of capital have limited
their interest in further expansion. Some banks that
expanded in Eastern Europe, in hopes of establishing a presence before countries acceded to the
European Union, suffered losses as competition
developed. Some that expanded in Latin America
have suffered losses from operations and from the
developments in Argentina. In the recent re-privatizations of Indonesian banks, only one bid came
from a well-known global bank. Lesser-known
banks have been expanding internationally, but
such banks can generate more supervision problems than local banks, because of the problems with
international supervision. Moreover, without reputations to lose, such banks may pull out when things
go bad in the country or in their home market,
leaving governments to bear the costs.
Improving Access to Finance
Increasing small clients’ access to finance is a critical issue for the financial sector in its support of
development. It involves the tradeoff between making banks safe and sound and making sure they
continue to intermediate.A prerequisite to increasing access is to reduce the absorption of loanable
resources by the government and the central bank.
Pressures remain great to direct low-cost credit
to small borrowers. Historically, however, these
efforts have usually been unsuccessful, undermining sustainable finance for rural and small and
medium-sized enterprises, just as occurred under
financial repression.
A few intermediaries have successfully sustained loans to small borrowers (box 7.8). The
more traditional banking operations among them
have common features that explain their success:
interest rates that cover costs, good deposit mobilization, containment of administrative costs, and a
233
high rate of loan collection, all backed by appropriate internal incentives for good staff performance (Yaron, Benjamin, and Piprek 1997).Their
example needs to be followed. The informational
infrastructure for small lending also improved
toward the end of the 1990s with the founding and
improvement of credit bureaus.
Greater competition in banking services,
through greater entry of banks and nonbanks and
looser regulations and supervision, is sometimes
recommended to improve access and lending in
general. Certainly, regulations should provide room
for intermediaries that take funds from groups of
well-informed investors/depositors and “nip at the
heels” of banks, by offering better returns to depositors (though with greater risk), along with better
service and innovation in products and lending.
Exactly how these entities should function—for
example as venture capital funds or deposit takers—
and where the lines should be drawn between them
and “banks,” are country-specific details. Such intermediaries operated in some East Asian and Latin
American countries and in India in the 1990s, and
BOX 7.8
Extending Credit for Small Borrowers
I
n addition to the well-known examples of
the Grameen Bank (begun in 1976) and
Bank Rakyat Indonesia after its 1983
reform (Robinson 2002), other successful
lenders began to expand toward the end of the
1990s. These included CrediFe in Ecuador,
MiBanco in Peru, CrediAmigo in Brazil, and, in
India, SEWAH (which uses a Grameen-type
approach) and self-help groups that use a mixture of the Grameen approach and traditional
banking. Some of these intermediaries received
support from donors. The Grameen approach
relies on the social responsibility of borrowers
who belong to a narrow group—an approach
that has also been used by some banks.
234
the outcomes illustrate their positive and negative
sides. Before they fell victim to crises in 1997, the
nonbank intermediaries increased finance for
underbanked sectors such as consumer durables and
construction. But to some extent their success was
not in competition and innovation but based on
regulatory arbitrage relative to banks, which were
constrained by interest rate controls (in India) or
tight money policy (in Thailand). A critical issue
with such intermediaries is whether politically they
can be denied access to the bank safety net, or
whether they should be regulated and supervised in
the same manner as banks to protect taxpayers as
well as depositors. India appropriately resisted bailing out depositors, but Thailand’s attempt to offer
these intermediaries access to liquidity funding
contributed to an easing of monetary policy that
was inconsistent with the pegged exchange rate.
Another related issue is the size of the
investor/depositor base: as it widens, the distinction
blurs between these institutions and banks, the pressures for claims on the safety net increase, and the
government may be drawn into supervision and
regulation. Such problems have occurred in co-op
banks in India and in countries such as Indonesia,
Nigeria, and Russia, where banks were allowed to
set up with negligible capital. In Indonesia, 48 of
these banks, many run by the politically well-connected, borrowed from the lender-of-last-resort
facility well in excess of their capital during the crisis (Kenward 2002), and used the funds to support
foreign exchange purchases and related businesses
(see box 7.5 above).
Improving access, as well as the quality of credit
allocation in general, depends heavily on improving
the informational, legal, and judicial framework.
The poor supply of information about borrowers,
though improving, limits lending to smaller clients.
In some countries, this problem has been circumvented by lending through third parties that in
effect guarantee the loans.53 More generally, however, better information would enhance competition for sound borrowers while giving borrowers
an incentive to service their loans to maintain good
credit records. Thus, the continued spread and
E C O N O M I C G ROW T H I N T H E 1 9 9 0 s
improvement of credit bureaus will be an important
development in improving access to credit as well as
the quality of loans. Important issues that need to
be addressed in this process are banking secrecy;
how to make banks comply promptly and accurately with the requirement to provide information; whether the credit bureau is to be private or
public; the inclusion of related information such as
installment purchases; and consumers’ rights to
challenge and amend the information.
Improvements in the legal and judicial framework, notably the definition and execution of collateral and bankruptcy laws, are also important in
improving credit access and lending in general.
Financial intermediaries prefer not to execute collateral—they are mobilizers and allocators of funds,
not managers of firms—but the threat of executing
collateral gives an incentive for prompt debt service. Good bankruptcy laws make the survival of
viable firms easier and allow shifts of physical capital from nonviable firms to others, with creditors
receiving the maximum settlement. The potential
to improve credit access through better information, contract enforcement, and technology is great:
in the United States, the cost of processing a small
loan is now below the price of a modest lunch.
Good access to financial services also involves
efficient deposit and payments services—important
facilities given the increase in domestic and international migration. In Africa, unfortunately, the
strengthening of the banking system has in some
cases reduced access to deposit and payments services for small transactions. In other parts of the
world, payments services are often limited and
uncompetitive. Post office banks—narrow banks,
holding only government debt—with better technology, and banks providing only these services (for
example in Tanzania and Mongolia) are examples of
innovative ways to serve these needs.
5. Conclusion
While financial liberalization delivered in some
aspects during the 1990s, its benefits are likely to lie
F I N A N C I A L L I B E R A L I Z AT I O N : W H AT W E N T R I G H T, W H AT W E N T W RO N G ?
in the future and to depend on further institutional
reforms. The crises of the 1990s, and the limited
contributions of liberalization to growth and access
to finance, reflect to a large degree the continuation
of the weak institutional framework related to the
overhang of the old financial system and, more fundamentally, the persistence of old political and economic power centers. The freeing of interest rates
and credit allocation increased resource mobilization. But the persistence of the former institutional
framework meant that resource allocation
improved less rapidly. Implicit and explicit guarantees, by removing market discipline, contributed to
excessive expansion of lending for the low-productivity projects of well-connected borrowers. Weak
regulation and supervision reflected not just technical problems but also political pressures for regulatory forbearance. Large, generalized liquidity
support during the crises often went to favored parties that bought foreign exchange with it. Information, which might have helped market discipline
and limited excessive lending had guarantees been
less, was not a focus of regulation, and it suffered
from the lack of transparency typical of many
developing countries. Limited credit access
reflected the crowding out of public sector and
central bank borrowing. In addition, it reflected a
lack of information related not only to technical
issues but also to the unwillingness of established
intermediaries to share information on their borrowers. Weak legal and judicial frameworks,
designed to protect borrowers and often responsive
to economic and political elites, reduced the incentives to service debts and made it difficult for new
borrowers to gain access to finance by pledging collateral effectively. Capital markets, which might
have absorbed some of the shocks, grew slowly
because of the weak institutional framework and
underlying structural problems.
The lessons of the 1990s are that improving the
contribution of finance to growth depends heavily
on macroeconomic stability, governments that are
willing to take steps to limit unsustainable booms, a
market-based approach, and the quality of institutions (financial intermediaries, information, and the
235
quality of the legal and regulatory framework).The
quality of institutions was not changed much by the
stroke-of-the-pen liberalizations of interest rates
and credit allocations. Improving these institutions,
and thereby improving financial intermediation,
will depend on institution building, better informational and legal frameworks, and, ultimately, more
competitive political systems. Success will depend
on a mix of increased market discipline and limiting
guarantees, better regulation and supervision that
includes encouraging greater market discipline of
intermediaries, greater participation of reputable
foreign banks, and capital market development.
Government is needed to support better markets,
without intervening excessively in them, backed by
an open political process that limits the distortions
of finance in favor of well-connected parties.
Notes
1. As Lenin cogently put it, “The big banks are the state
apparatus which we need to bring about socialism and
which we take readymade from capitalism” (quoted in
LaPorta,López de Silanes,and Shleifer 2002a,266).Thus
communist, socialist, and planned economies nationalized domestic and foreign commercial banks. Gerschenkron (1962) was among the first to provide
academic support for the provision by government and
state banks of funds for industrialization and long-term
credit. In addition to state banks, specialized development finance intermediaries, generally public, were set
up to provide credits for small-scale industry, agriculture, housing, and long-term industrial credit. They
were financed by government-guaranteed external borrowing, including bilateral and multilateral loans; by
low-cost directed credits from banks and other intermediaries; and by government revenues. Often these
intermediaries went bankrupt, reflecting failures to collect debt service and dependence on unhedged external
borrowing.
2. For example, Brownbridge and Harvey (1998) describe
such financial repression in Africa.
3. Dornbusch and Edwards (1991); Alesina, Grilli, and
Milesi-Ferreti (1994); and Garrett (1995, 2000).
4. Estimates of aggregate subsidies range from 3 to 8 percent of GDP annually (World Bank, World Development
Report 1989; Hanson 2001). Regarding allocations, in
Costa Rica in the mid-1970s for example, the public
Banco Nacional’s interest rate subsidy on agricultural
E C O N O M I C G ROW T H I N T H E 1 9 9 0 s
236
5.
6.
7.
8.
9.
10.
11.
12.
credits was equal to about 4 percent of GDP and 20
percent of agricultural value added.About 80 percent of
the credit went to 10 percent of the borrowers; the average subsidy on these loans alone would have put each
recipient into the upper 10 percent of the income distribution (World Bank, World Development Report 1989).
The situation in other countries was similar. See Adams
and Vogel (1986); Adams, Graham, and Von Pischke
(1984); Gonzalez-Vega (1984); and Yaron, Benjamin,
and Piprek (1997). Larger firms often accessed directed
credit and on-lent it to their suppliers, capturing the
spread between repressed and free rates. Directed credits were also diverted into loans with free rates, for
example through curb markets, or, when some deposit
rates were freed, into deposits that paid higher rates than
the loan rates on directed credits.
Abiad and Mody (2003) note the link between greater
openness to trade and financial liberalization.
Capital controls, particularly in the context of macroeconomic imbalances, increase incentives for corruption, worsen the income distribution, and, because they
fail, create disrespect for laws. Even in the 1970s, a high
proportion of the massive capital inflows into Latin
America leaked out (Dooley et al. 1986). More recently,
in China, net short-term outflows of capital and errors
and omissions in the balance of payments were very
large (World Bank 1997a, 2000c).
For example, in Mexico after the post-1982 high inflation, the limits on interest rates on agricultural loans
were below the rates on some deposits for a period.
Rural borrowers often simply took their loan proceeds
and deposited them, earning a positive return on the
loans with much less effort than by farming.
Abiad and Mody (2003).
Stock markets were opened to foreign investors
between 1986 and 1993 in the major East Asian and
Latin American countries and in India and Pakistan
(Bekaert, Harvey, and Lundblad 2003).
Levine and Zervos (1998); Levine, Loayza, and Beck
(2000).
The sharp fall in inflation in the 1990s made interest
rates more realistic, even with declines in nominal rates;
it also reduced other financial distortions associated with
inflation. Among the 25 developing countries with the
largest financial systems, those with hyperinflation at the
beginning of the 1990s reduced inflation sharply (in
some cases, such as Argentina, to single digits), while
most of those with initial inflation of 10–50 percent
annually reduced inflation to single digits by 2000. In
Africa, inflation also fell and in most transition countries, inflation fell sharply from initial high levels.
Foreign currency holdings also were often large relative
to financial systems (Hanson 2002).
13. As an example of the popularity of these measures, in
Peru after hyperinflation at the end of the 1980s, the
1993 Constitution (Article 64) guaranteed citizens the
right to hold and use foreign exchange. More than 50
percent of deposits are in dollars, even in the non-Lima
savings banks.
14. The interest rates on foreign currency credits avoid the
high, up-front cost of an expected depreciation that
may not occur for some time—the “peso
problem”(Hanson 2002). This improves cash flows
(lower deficits for governments using cash accounting)
and increases a loan’s effective maturity. Moreover,
when a depreciation does come, the cost is spread out
in the amortization period. Not surprisingly, governments borrow externally and, many countries, for
example Mexico in 1994 and Brazil and Turkey
recently, have indexed some domestic debt to foreign
currency. For private firms, there is also the hope that a
depreciation may lead to a government bailout, either
by a favorable takeover of their foreign loans or an
asymmetric conversion of domestic foreign currency
debts and deposits to local currency, as occurred in
Mexico (1982) and Argentina (2002). However, foreign
currency loans do increase bank risks, even when
matched with foreign currency deposits, since the borrowers may not have easy access to foreign currency
earnings. Banks could have adjusted the foreign and
domestic currency proportions of their balance sheets
by varying interest rate differentials, but, given the
demand for foreign currency deposits, the spread probably would have been high, creating moral hazard problems in loans in domestic currency.
15. These figures understate the relative growth of public
sector debt because they include China, where deposit
growth was large and banks’ accumulation of government debt was relatively small, but the accumulation of
state enterprise debt was large. In those transition countries for which relevant data are available, privatization
reduced borrowing by public enterprises, thereby offsetting the rise in government debt, but deposits grew
only slowly and were largely absorbed by increased central bank debt.
16. Note that these figures understate the growth of private
credit in India and East Asia before 1997 and overstate it
after 1997, because of the growth and decline of the
nonbank sector.
17. Government debt was either injected into the banks as
part of restructurings or, in the case of deficit finance,
sold at whatever rates would ensure its purchase.Thus,
as a first-order approximation, the supply was inelastic
(except for changes in the proportions sold internally
and externally).The liquidity, low risk, and low capital
requirements on government debt affected only the rate
F I N A N C I A L L I B E R A L I Z AT I O N : W H AT W E N T R I G H T, W H AT W E N T W RO N G ?
18.
19.
20.
21.
22.
23.
24.
25.
differential between the debt and private credit that was
needed to crowd out the equivalent amount of private
credit, rather than the amount of government debt held,
which was determined by the inelastic supply.
In some cases, the central banks also temporarily acted
as large lenders of last resort.
The increase in external assets probably reflected an
attempt to hedge the risks from their foreign currency
liabilities, including deposits (Honahan and Shi 2002).
Although banks’ net external positions were small in
2000, gross external assets and liabilities were much
larger than earlier (Hanson 2003b), suggesting that
financial liberalization had increased banks’ ability to
diversify themselves.
For statistical evidence on the importance of private
sector credit in growth see Levine and Zervos (1998);
Levine, Loayza, and Beck (2000). The evidence of the
link between savings/investment and financial sector
liberalization is mixed (see, for example, Bandiera et al.
2000), but the investment ratio does seem to have risen
in the 1990s in the larger Asian countries, though not in
the larger Latin American countries and it actually
declined in the larger African countries.The difference
between saving and investment ratios may, of course,
reflect differences in capital inflows.
Crises, unproductive credits, and their links to the unreformed institutional and political framework that
remained after liberalization are discussed in the section
below on financial crises.
Stock markets were reported as of 1991 in Hungary
and Poland; in 1994 in Croatia, the Czech Republic,
Romania, Russia, the Slovak Republic, and Slovenia; in
1995 in Bulgaria, Latvia, Lithuania, and Mongolia; in
1996 in the Former Yugoslav Republic of Macedonia,
Moldova, and Uzbekistan; and in 1997 in Estonia,
Kazakhstan, and Ukraine (Standard and Poor’s 2003).
This average is for the 17 of the 25 largest financial markets for which data are available on banks’ domestic
credit to the private sector. It excludes China, India, and
Korea, which do not report separate data on private
sector credits. These three countries are large external
borrowers in absolute terms but are likely to have
smaller ratios of private external borrowings to bank
credit than the average for the 17 countries.
The additional currency risk of these funds was less than
it might seem, as domestic credit in many countries was
increasingly denominated in foreign exchange.
“[The state banks’] commercialization as joint stock
companies was not accompanied by sufficient commercialization of their credit management, product development, service levels, operational efficiency, or risk
management.All this meant poor loan performance and
eventually insolvency. Many factors worked against
26.
27.
28.
29.
30.
237
early detection of such problems—poor accounting and
auditing standards, inexperienced supervisory personnel, inadequate prudential regulations, decentralized and
incomplete information systems (often branch accounts
not consolidated with headquarters accounts) and the
traditional reliance on the government for additional
funding when liquidity became short.… Management
information systems were weak. All these factors
worked against timely and effective scrutiny of management behavior” (Sherif, Borish, and Gross 2003, 21–22).
Western European banks entered Eastern Europe hoping to gain market shares before the European Union
expanded.The shares of foreign banks in the number of
banks and in total bank assets grew rapidly in Bulgaria,
the Czech Republic, Hungary, and Poland. In Russia
and Ukraine, however, foreign banks represented only a
small fraction of the total number of banks, even in 2000
(Sherif, Borish, and Gross 2003). In Latin America,
Spanish banks became a major force by taking over state
and private banks. In Africa, foreign banks reentered and
South African banks were playing an increasing role in
southern Africa at the end of the 1990s.
Research suggests that in Latin America foreign banks
are at least as good as domestic banks at lending to small
firms (Clarke et al. 2004), and in India foreign banks’
lending to small and medium-size firms has grown faster
than that of state banks.
Indonesia took liberalizing bank entry to an extreme,
with almost “free banking” (box 7.5). Russia and Nigeria later followed a similar approach. Most new banks in
these countries were “pocket” banks, capturing funds
for their owners’ firms. In Indonesia, these banks were
hit hard by the crisis and proved costly to the government when deposits were guaranteed.
Caprio and Klingebiel (2002) list 117 systemic financial
crises (in which most of banks’ capital was exhausted) in
93 countries and 51 borderline crises in the period
1970–99. See also Sundararajan and Balino (1991) and
World Bank, World Development Report 1989.
Argentina, Russia, and some African countries had high
public sector debt compared to public revenues (IMF
2004a). Other countries, notably in East Asia, had high
private debt, including high external private debt, relative to GDP.Variants of exchange rate–based stabilization were being used by Argentina, Chile, and Uruguay
in the late 1970s and by Argentina, Brazil, and Mexico
in the 1990s. Other countries, notably the East Asian
countries and Turkey in the 1990s, limited the flexibility of their exchange rates. The relation between the
1990s crises and the current account deficits is similar to
but not the same as “Generation I” models of balance of
payments crises (Krugman 1979). In the 1990s crises,
the problem was not just financing the current account
E C O N O M I C G ROW T H I N T H E 1 9 9 0 s
238
31.
32.
33.
34.
35.
36.
37.
38.
deficit but net amortizations of long- and short-term
loans, which could change suddenly.
Portfolio adjustments to improved investment opportunities generate rapid inflows initially, followed by a slowdown in inflows and net negative foreign exchange
flows (because of interest payments that require internal
adjustment).
See, for example, Demirgüç-Kunt and Detragiache
(2002); and Kaminsky and Reinhart (1999). In the crises
of the early 1980s, high U.S. interest rates, as well as the
fall in petroleum prices, probably played a role, while
lower interest rates contributed to the large capital
inflows to developing countries in the early 1990s and
again recently.The rise in international interest rates that
started in 1993 probably contributed to a gradual tightening of credit conditions for developing countries.
A substantial literature has evolved over the possibility
that the crises in the 1990s, particularly those in East
Asia, reflected contagion in financial markets, not fundamentals; see Claessens and Forbes (2001) and works
cited there. Contagion is one explanation of “Generation II” models of crises in which there are multiple
equilibria, associated with high and low rates of capital
inflow. No doubt international investors exhibit some
herding behavior for various reasons. Another explanation is that events in one country could lead external investors to reevaluate the subjective risks in others
and reduce their exposures.This also would seem like
contagion.
The lag between liberalization and crises seems fairly
long (Demirgüç-Kunt and Detragiache 2001, 105).The
lag may also reflect the difficulty of pinpointing liberalization and crises, both of which occur over time, as discussed in Eichengreen (2001). Demirgüç-Kunt and
Detragiache (2001) date liberalization from the removal
of some interest rate controls and note that the estimated lag may reflect the gradualness of interest rate liberalization. Of course, the initial rise in deposit interest
rates may also reflect part of a defense against a run on
the currency, as for example in India in 1991. The lag
between financial crises and currency crises may reflect
liquidity support to weak banks at the start of financial
crises, as discussed below.
See Diaz Alejandro (1985); the capsule discussions of
country experience in Sundararajan and Balino (1991,
40–49); and the descriptions of financial crises in
Kindleberger (2000).
Of course, this explanation is related to Generation II
models of crises, discussed in footnote 33.
State banks have not been closed without paying off
depositors, except in a few African countries.
The United States has required intervention in weak
banks well before capital is exhausted, and explanations
39.
40.
41.
42.
43.
44.
45.
46.
47.
48.
49.
50.
if bank failures lead to deposit insurance payments (Benston and Kaufmann 1997). It is unclear how well this
approach would work in developing countries.
Even if small depositors are promptly paid off, large
depositors may switch to foreign exchange.
Arioshi et al. (2000); Dooley (1996).The Malaysian controls are often cited as an example of effective controls,
but they were put in place after the crisis was largely
over (World Bank 2000c).
To paraphrase William McChesney Martin, former
chairman of the U.S. Federal Reserve Board, the role of
governments is to take away the punchbowl before the
party gets too wild.
Such government behavior occurs not only in developing countries but also in industrial countries, for
example in the U.S. savings and loan sector before its
crisis.
This weakness would have existed even if good information had been available.
Interestingly, additional deposits often flowed into state
banks during these periods. Despite the weakness of
their lending, the public typically considered them to
have better guarantees.These banks, in turn, often made
additional loans to weak borrowers.
See, for example, Klingen et al. (2004).
Financial liberalizations, even gradual ones, are not easy
to manage. Errors in liberalization are not always technical; they sometimes reflect pressures by influential
groups.
Financial liberalization also tended to increase the fiscal
deficit and make it more costly to finance, as the government lost seigniorage revenues and had to pay more
market-based interest rates on its debt.
World Bank (1998a) describes the substantial strengthening of Argentina’s financial system in the mid-1990s.
Some policies and some countries will of course deviate from the general trends. Some governments where
democracy is limited may attempt to impose capital
controls and return to the inflation tax as a means of
capturing resources. And many countries remain concerned about the narrowness of credit access for their
citizens, and seek ways to provide funds for rural and
small and medium-size enterprise lending at belowmarket rates through specialized intermediaries,
notwithstanding the past failures of this approach and
the increases in access that are occurring.
Such debt is not completely bad—it can serve as a liquid asset to improve the payments system and as a way
for individual banks to deal with limited runs. However,
governments’ low revenue-generating capacities make it
difficult to service these debts, lead to cuts in public
social and infrastructure spending, and divert governments from developmental issues by the day-to-day
F I N A N C I A L L I B E R A L I Z AT I O N : W H AT W E N T R I G H T, W H AT W E N T W RO N G ?
problem of rolling over the debt, raising the risk of a
return to inflationary finance.These potential problems
have been eased by the fall in interest rates worldwide.
However, when interest rates begin to rise again, and
the costs of debt service correspondingly increase, the
problems may reappear.
51. International equity market markets can also act as a
shock absorber, but only the largest and most transparent firms can list in these markets. Offshore bond markets also are developing in private as well as public
bonds; they reduce the risk of credit crunches but
increase currency risk.
239
52. Protecting supervisors completely from legal action
raises another issue, the risk that they will engage in
malfeasance. Hence, a tribunal separate from the court
system is needed to deal with accusations of malfeasance
by supervisors.
53. For example, making loans for scooters, cars, and homes
to workers in the formal sector who often cannot be
fired; making loans to farmers that are repaid by deductions from the contracts the farmers have with crop
buyers; and lending to small and medium-size enterprises either through larger firms or by discounting their
orders from such firms.